[Federal Register Volume 71, Number 185 (Monday, September 25, 2006)]
[Proposed Rules]
[Pages 55829-55958]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 06-7656]
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Part II
Department of the Treasury
Office of the Comptroller of the Currency
Office of Thrift Supervision
12 CFR Part 3 and 566
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Federal Reserve System
12 CFR Parts 208 and 225
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Federal Deposit Insurance Corporation
12 CFR Part 325
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Risk-Based Capital Standards: Advanced Capital Adequacy Framework and
Market Risk; Proposed Rules and Notices
Federal Register / Vol. 71, No. 185 / Monday, September 25, 2006 /
Proposed Rules
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DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
12 CFR Part 3
[Docket No. 06-09]
RIN 1557-AC91
FEDERAL RESERVE SYSTEM
12 CFR Parts 208 and 225
[Regulations H and Y; Docket No. R-1261]
FEDERAL DEPOSIT INSURANCE CORPORATION
12 CFR Part 325
RIN 3064-AC73
DEPARTMENT OF THE TREASURY
Office of Thrift Supervision
12 CFR Part 566
RIN 1550-AB56
Risk-Based Capital Standards: Advanced Capital Adequacy Framework
AGENCIES: Office of the Comptroller of the Currency, Treasury; Board of
Governors of the Federal Reserve System; Federal Deposit Insurance
Corporation; and Office of Thrift Supervision, Treasury.
ACTION: Joint notice of proposed rulemaking.
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SUMMARY: The Office of the Comptroller of the Currency (OCC), the Board
of Governors of the Federal Reserve System (Board), the Federal Deposit
Insurance Corporation (FDIC), and the Office of Thrift Supervision
(OTS) (collectively, the agencies) are proposing a new risk-based
capital adequacy framework that would require some and permit other
qualifying banks \1\ to use an internal ratings-based approach to
calculate regulatory credit risk capital requirements and advanced
measurement approaches to calculate regulatory operational risk capital
requirements. The proposed rule describes the qualifying criteria for
banks required or seeking to operate under the proposed framework and
the applicable risk-based capital requirements for banks that operate
under the framework.
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\1\ For simplicity, and unless otherwise indicated, this notice
of proposed rulemaking (NPR) uses the term ``bank'' to include
banks, savings associations, and bank holding companies (BHCs). The
terms ``bank holding company'' and ``BHS'' refer only to bank
holding companies regulated by the board and do not include savings
and loan holding companies regulated by the OTS.
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DATES: Comments must be received on or before January 23, 2007.
ADDRESSES: Comments should be directed to:
OCC: You should include OCC and Docket Number 06-09 in your
comment. You may submit comments by any of the following methods:
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
OCC Web Site: http://www.occ.treas.gov. Click on ``Contact
the OCC,'' scroll down and click on ``Comments on Proposed
Regulations.''
E-mail address: [email protected].
Fax: (202) 874-4448.
Mail: Office of the Comptroller of the Currency, 250 E
Street, SW., Mail Stop 1-5, Washington, DC 20219.
Hand Delivery/Courier: 250 E Street, SW., Attn: Public
Information Room, Mail Stop 1-5, Washington, DC 20219.
Instructions: All submissions received must include the agency name
(OCC) and docket number or Regulatory Information Number (RIN) for this
notice of proposed rulemaking. In general, OCC will enter all comments
received into the docket without change, including any business or
personal information that you provide. You may review comments and
other related materials by any of the following methods:
Viewing Comments Personally: You may personally inspect
and photocopy comments at the OCC's Public Information Room, 250 E
Street, SW., Washington, DC. You can make an appointment to inspect
comments by calling (202) 874-5043.
Board: You may submit comments, identified by Docket No. R-1261, by
any of the following methods:
Agency Web Site: http://www.federalreserve.gov. Follow the
instructions for submitting comments at http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm.
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
E-mail: [email protected]. Include docket
number in the subject line of the message.
FAX: 202/452-3819 or 202/452-3102.
Mail: Jennifer J. Johnson, Secretary, Board of Governors
of the Federal Reserve System, 20th Street and Constitution Avenue,
NW., Washington, DC 20551.
All public comments are available from the Board's Web site at
www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as submitted,
unless modified for technical reasons. Accordingly, your comments will
not be edited to remove any identifying or contact information. Public
comments may also be viewed electronically or in paper in Room MP-500
of the Board's Martin Building (20th and C Streets, NW.) between 9 a.m.
and 5 p.m. on weekdays.
FDIC: You may submit comments, identified by RIN number, by any of
the following methods:
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
Agency Web Site: http://www.fdic.gov/regulations/laws/federal/propose.html.
Mail: Robert E. Feldman, Executive Secretary, Attention:
Comments, Federal Deposit Insurance Corporation, 550 17th Street, NW.,
Washington, DC 20429.
Hand Delivery/Courier: Guard station at rear of the 550
17th Street Building (located on F Street) on business days between 7
a.m. and 5 p.m.
E-mail: [email protected].
Public Inspection: Comments may be inspected at the FDIC
Public Information Center, Room E-1002, 3502 Fairfax Drive, Arlington,
VA 22226, between 9 a.m. and 5 p.m. on business days.
Instructions: Submissions received must include the agency name and
RIN for this rulemaking. Comments received will be posted without
change to http://www.fdic.gov/regulations/laws/federal/propose.html
including any personal information provided.
OTS: You may submit comments, identified by No. 2006-33, by any of
the following methods:
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
E-mail address: [email protected]. Please
include No. 2006-33 in the subject line of the message and include your
name and telephone number in the message.
Fax: (202) 906-6518.
Mail: Regulation Comments, Chief Counsel's Office, Office
of Thrift Supervision, 1700 G Street, NW., Washington, DC 20552,
Attention: No. 2006-33.
Hand Delivery/Courier: Guard's Desk, East Lobby Entrance,
1700 G Street, NW., from 9 a.m. to 4 p.m. on business days, Attention:
Regulation Comments, Chief Counsel's Office, Attention: No. 2006-33.
Instructions: All submissions received must include the agency name
and
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docket number or Regulatory Information Number (RIN) for this
rulemaking. All comments received will be posted without change to the
OTS Internet Site at http://www.ots.treas.gov/pagehtml.cfm?catNumber=67&an=1, including any personal information
provided.
Docket: For access to the docket to read background documents or
comments received, go to http://www.ots.treas.gov/pagehtml.cfm?catNumber=67&an=1.
In addition, you may inspect comments at the Public Reading Room,
1700 G Street, NW., by appointment. To make an appointment for access,
call (202) 906-5922, send an e-mail to public.info@ots.treas.gov">public.info@ots.treas.gov, or
send a facsimile transmission to (202) 906-7755. (Prior notice
identifying the materials you will be requesting will assist us in
serving you.) We schedule appointments on business days between 10 a.m.
and 4 p.m. In most cases, appointments will be available the next
business day following the date we receive a request.
FOR FURTHER INFORMATION CONTACT:
OCC: Roger Tufts, Senior Economic Advisor, Capital Policy (202-874-
4925) or Ron Shimabukuro, Special Counsel, Legislative and Regulatory
Activities Division (202-874-5090). Office of the Comptroller of the
Currency, 250 E Street, SW., Washington, DC 20219.
Board: Barbara Bouchard, Deputy Associate Director (202-452-3072 or
[email protected]) or Anna Lee Hewko, Senior Supervisory
Financial Analyst (202-530-6260 or [email protected]), Division of
Banking Supervision and Regulation; or Mark E. Van Der Weide, Senior
Counsel (202-452-2263 or [email protected]), Legal Division. For
users of Telecommunications Device for the Deaf (``TDD'') only, contact
202-263-4869.
FDIC: Jason C. Cave, Associate Director, Capital Markets Branch,
(202) 898-3548, Bobby R. Bean, Senior Quantitative Risk Analyst,
Capital Markets Branch, (202) 898-3575, Kenton Fox, Senior Capital
Markets Specialist, Capital Markets Branch, (202) 898-7119, Division of
Supervision and Consumer Protection; or Michael B. Phillips, Counsel,
(202) 898-3581, Supervision and Legislation Branch, Legal Division,
Federal Deposit Insurance Corporation, 550 17th Street, NW.,
Washington, DC 20429.
OTS: Michael D. Solomon, Director, Capital Policy, Supervision
Policy (202) 906-5654; David W. Riley, Senior Analyst, Capital Policy
(202) 906-6669; or Karen Osterloh, Special Counsel, Regulations and
Legislation Division (202) 906-6639, Office of Thrift Supervision, 1700
G Street, NW., Washington, DC 20552.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction
A. Background
B. Conceptual Overview
1. The IRB Framework for Credit Risk
2. The AMA for Operational Risk
C. Overview of Proposed Rule
D. Structure of Proposed Rule
E. Quantitative Impact Study 4 and Overall Capital Objectives
1. Quantitative Impact Study 4
2. Overall Capital Objectives
F. Competitive Considerations
II. Scope
A. Core and Opt-In Banks
B. U.S. Depository Institution Subsidiaries of Foreign Banks
C. Reservation of Authority
III. Qualification
A. The Qualification Process
1. In General
2. Parallel Run and Transitional Floor Periods
B. Qualification Requirements
1. Process and Systems Requirements
2. Risk Rating and Segmentation Systems for Wholesale and Retail
Exposures
Wholesale exposures
Retail exposures
Definition of default
Rating philosophy
Rating and segmentation reviews and updates
3. Quantification of Risk Parameters for Wholesale and Retail
Exposures
Probability of default (PD)
Loss given default (LGD) and expected loss given default (ELGD)
Exposure at default (EAD)
General quantification principles
4. Optional Approaches That Require Prior Supervisory Approval
5. Operational Risk
Operational risk data and assessment system
Operational risk quantification system
6. Data Management and Maintenance
7. Control and Oversight Mechanisms
Validation
Internal audit
Stress testing
8. Documentation
C. Ongoing Qualification
IV. Calculation of Tier 1 Capital and Total Qualifying Capital
V. Calculation of Risk-Weighted Assets
A. Categorization of Exposures
1. Wholesale Exposures
2. Retail Exposures
3. Securitization Exposures
4. Equity Exposures
5. Boundary Between Operational Risk and Other Risks
6. Boundary Between the Proposed Rule and the Market Risk
Amendment
B. Risk-Weighted Assets for General Credit Risk (Wholesale
Exposures, Retail Exposures, On-Balance Sheet Assets That Are Not
Defined by Exposure Category, and Immaterial Credit Exposures)
1. Phase 1--Categorization of Exposures
2. Phase 2--Assignment of Wholesale Obligors and Exposures to
Rating Grades and Retail Exposures to Segments
Purchased wholesale receivables
Wholesale lease residuals
3. Phase 3--Assignment of Risk Parameters to Wholesale Obligors
and Exposures and Retail Segments
4. Phase 4--Calculation of Risk-Weighted Assets
5. Statutory Provisions on the Regulatory Capital Treatment of
Certain Mortgage Loans
C. Credit Risk Mitigation Techniques
1. Collateral
2. EAD for Counterparty Credit Risk
EAD for repo-style transactions and eligible margin loans
Collateral haircut approach
Standard supervisory haircuts
Own estimates of haircuts
Simple VaR methodology
3. EAD for OTC Derivative Contracts
Current exposure methodology
4. Internal Models Methodology
Maturity under the internal models methodology
Collateral agreements under the internal models methodology
Internal estimate of alpha
Alternative models
5. Guarantees and Credit Derivatives That Cover Wholesale
Exposures
Eligible guarantees and eligible credit derivatives
PD substitution approach
LGD adjustment approach
Maturity mismatch haircut
Restructuring haircut
Currency mismatch haircut
Example
Multiple credit risk mitigants
Double default treatment
6. Guarantees and Credit Derivatives That Cover Retail Exposures
D. Unsettled Securities, Foreign Exchange, and Commodity
Transactions
E. Securitization Exposures
1. Hierarchy of Approaches
Exceptions to the general hierarchy of approaches
Servicer cash advances
Amount of a securitization exposure
Implicit support
Operational requirements for traditional securitizations
Clean-up calls
2. Ratings-Based Approach (RBA)
3. Internal Assessment Approach (IAA)
4. Supervisory Formula Approach (SFA)
General requirements
Inputs to the SFA formula
5. Eligible Disruption Liquidity Facilities
6. Credit Risk Mitigation for Securitization Exposures
7. Synthetic Securitizations
Background
Operational requirements for synthetic securitizations
First-loss tranches
Mezzanine tranches
Super-senior tranches
8. Nth-to-Default Credit Derivatives
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9. Early Amortization Provisions
Background
Controlled early amortization
Noncontrolled early amortization
F. Equity Exposures
1. Introduction and Exposure Measurement
Hedge transactions
Measures of hedge effectiveness
2. Simple Risk-Weight Approach (SRWA)
Non-significant equity exposures
3. Internal Models Approach (IMA)
IMA qualification
Risk-weighted assets under the IMA
4. Equity Exposures to Investment Funds
Full look-through approach
Simple modified look-through approach
Alternative modified look-through approach
VI. Operational Risk
VII. Disclosure
1. Overview
Comments on ANPR
2. General Requirements
Frequency/timeliness
Location of disclosures and audit/certification requirements
Proprietary and confidential information
3. Summary of Specific Public Disclosure Requirements
4. Regulatory Reporting
I. Introduction
A. Background
On August 4, 2003, the agencies issued an advance notice of
proposed rulemaking (ANPR) (68 FR 45900) that sought public comment on
a new risk-based regulatory capital framework based on the Basel
Committee on Banking Supervision (BCBS)\2\ April 2003 consultative
paper entitled `` New Basel Capital Accord'' (Proposed New Accord). The
Proposed New Accord set forth a ``three pillar'' framework encompassing
risk-based capital requirements for credit risk, market risk, and
operational risk (Pillar 1); supervisory review of capital adequacy
(Pillar 2); and market discipline through enhanced public disclosures
(Pillar 3). The Proposed New Accord incorporated several methodologies
for determining a bank's risk-based capital requirements for credit,
market, and operational risk.\3\
The ANPR sought comment on selected regulatory capital approaches
contained in the Proposed New Accord that the agencies believe are
appropriate for large, internationally active U.S. banks. These
approaches include the internal ratings-based (IRB) approach for credit
risk and the advanced measurement approaches (AMA) for operational risk
(together, the advanced approaches). The IRB framework uses risk
parameters determined by a bank's internal systems in the calculation
of the bank's credit risk capital requirements. The AMA relies on a
bank's internal estimates of its operational risks to generate an
operational risk capital requirement for the bank. The ANPR included a
number of questions highlighting various issues for the industry's
consideration. The agencies received approximately 100 public comments
on the ANPR from banks, trade associations, supervisory authorities,
and other interested parties. These comments addressed the agencies'
specific questions as well as a range of other issues. Commenters
generally encouraged further development of the framework, and most
supported the overall direction of the ANPR. Commenters did, however,
raise a number of conceptual and technical issues that they believed
required additional consideration.
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\2\ The BCBS is a committee of banking supervisory authorities,
which was established by the central bank governors of the G-10
countries in 1975. It consists of senior representatives of bank
supervisory authorities and central banks from Belgium, Canada,
France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain,
Sweden, Switzerland, the United Kingdom, and the United States.
\3\ The BCBS developed the Proposed New Accord to modernize its
first capital Accord, which was endorsed by the G-10 governors in
1988 and implemented by the agencies in the United States in 1989.
The BCBS's 1988 Accord is described in a document entitled
``International Convergence of Capital Measurement and Capital
Standards.'' This document and other documents issued by the BCBS
are available through the Bank for International Settlements Web
site at http://www.bis.org. The agencies' implementing regulations
are available at 12 CFR part 3, Appendices A and B (national banks);
12 CFR part 208, Appendices A and E (state member banks); 12 CFR
part 225, Appendixes A and E (bank holding companies); 12 CFR part
325, Appendices A and C (state nonmember banks); and 12 CFR part 567
(savings associations).
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Since the issuance of the ANPR, the agencies have worked
domestically and with other BCBS member countries to modify the
methodologies in the Proposed New Accord to reflect comments received
during the international consultation process and the U.S. ANPR comment
process. In June 2004, the BCBS issued a document entitled
``International Convergence of Capital Measurement and Capital
Standards: A Revised Framework'' (New Accord or Basel II). The New
Accord recognizes developments in financial products, incorporates
advances in risk measurement and management practices, and assesses
capital requirements that are generally more sensitive to risk. It is
intended for use by individual countries as the basis for national
consultation and implementation. Accordingly, the agencies are issuing
this proposed rule to implement the New Accord for banks in the United
States.
B. Conceptual Overview
The framework outlined in this proposal (IRB framework) is intended
to produce risk-based capital requirements that are more risk-sensitive
than the existing risk-based capital rules of the agencies (general
risk-based capital rules). The proposed framework seeks to build on
improvements to risk assessment approaches that a number of large banks
have adopted over the last decade. In particular, the proposed
framework requires banks to assign risk parameters to exposures and
provides specific risk-based capital formulas that would be used to
transform these risk parameters into risk-based capital requirements.
The proposed framework is based on the ``value-at-risk'' (VaR)
approach to measuring credit risk and operational risk. VaR modeling
techniques for measuring risk have been the subject of economic
research and are used by large banks. The proposed framework has
benefited significantly from comments on the ANPR, as well as
consultations organized in conjunction with the BCBS's development of
the New Accord. Because bank risk measurement practices are both
continually evolving and subject to model and other errors, the
proposed framework should be viewed less as an effort to produce a
statistically precise measurement of risk, and more as an effort to
improve the risk sensitivity of the risk-based capital requirements for
banks.
The proposed framework's conceptual foundation is based on the view
that risk can be quantified through the assessment of specific
characteristics of the probability distribution of potential losses
over a given time horizon. This approach assumes that a suitable
estimate of that probability distribution, or at least of the specific
characteristics to be measured, can be produced. Figure 1 illustrates
some of the key concepts associated with the proposed framework. The
figure shows a probability distribution of potential losses associated
with some time horizon (for example, one year). It could reflect, for
example, credit losses, operational losses, or other types of losses.
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[GRAPHIC] [TIFF OMITTED] TP25SE06.075
The area under the curve to the right of a particular loss amount
is the probability of experiencing losses exceeding this amount within
a given time horizon. The figure also shows the statistical mean of the
loss distribution, which is equivalent to the amount of loss that is
``expected'' over the time horizon. The concept of ``expected loss''
(EL) is distinguished from that of ``unexpected loss'' (UL), which
represents potential losses over and above the expected loss amount. A
given level of unexpected loss can be defined by reference to a
particular percentile threshold of the probability distribution. In the
figure, for example, the 99.9th percentile is shown. Unexpected losses,
measured at the 99.9th percentile level, are equal to the value of the
loss distribution corresponding to the 99.9th percentile, less the
amount of expected losses. This is shown graphically at the bottom of
the figure.
The particular percentile level chosen for the measurement of
unexpected losses is referred to as the ``confidence level'' or the
``soundness standard'' associated with the measurement. If capital is
available to cover losses up to and including this percentile level,
then the bank will remain solvent in the face of actual losses of that
magnitude. Typically, the choice of confidence level or soundness
standard reflects a very high percentile level, so that there is a very
low estimated probability that actual losses would exceed the
unexpected loss amount associated with that confidence level or
soundness standard.
Assessing risk and assigning regulatory capital requirements by
reference to a specific percentile of a probability distribution of
potential losses is commonly referred to as a VaR approach. Such an
approach was adopted by the FDIC, Board, and OCC for assessing a bank's
risk-based capital requirements for market risk in 1996 (market risk
amendment or MRA). Under the MRA, a bank's own internal models are used
to estimate the 99th percentile of the bank's market risk loss
distribution over a ten-business-day horizon. The bank's market risk
capital requirement is based on this VaR estimate, generally multiplied
by a factor of three. The agencies implemented this multiplication
factor to provide a prudential buffer for market volatility and
modeling error.
1. The IRB Framework for Credit Risk
The conceptual foundation of this proposal's approach to credit
risk capital requirements is similar to the MRA's approach to market
risk capital requirements, in the sense that each is VaR-oriented. That
is, the proposed framework bases minimum credit risk capital
requirements largely on estimated statistical measures of credit risk.
Nevertheless, there are important differences between this proposal and
the MRA. The MRA approach for assessing market risk capital
requirements currently employs a nominal confidence level of 99.0
percent and a ten-business-day horizon, but otherwise provides banks
with substantial modeling flexibility in determining their market risk
loss distribution and capital requirements. In contrast, the IRB
framework for assessing credit risk capital requirements is based on a
99.9 percent nominal confidence level, a one-year horizon, and a
supervisory model of credit losses embodying particular assumptions
about the underlying drivers of portfolio credit risk, including loss
correlations among different asset types.\4\
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\4\ The theoretical underpinnings for the supervisory model of
credit risk underlying this proposal are provided in Michael Gordy,
``A Risk-Factor Model Foundation for Ratings-Based Bank Capital
Rules,'' Journal of Financial Intermediation, July 2003. The IRB
formulas are derived as an application of these results to a single-
factor CreditMetrics-style model. For mathematical details on this
model, see Michael Gordy, ``A Comparative Anatomy of Credit Risk
Models,'' Journal of Banking and Finance, January 2000, or H.U.
Koyluogu and A. Hickman, ``Reconcilable Differences,'' Risk, October
1998. For a less technical overview of the IRB formulas, see the
BCBS's ``An Explanatory Note on the Basel II Risk Weight
Functions,'' July 2005 (Explanatory Note). The document can be found
on the Bank for International Settlements Web site at http://www.bis.org.
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The IRB framework is broadly similar to the credit VaR approaches
used by many banks as the basis for their internal assessment of the
economic capital necessary to cover credit risk. It is common for a
bank's internal credit risk models to consider a one-year loss horizon,
and to focus on a high loss threshold confidence level. As with the
internal credit VaR models used by banks, the output of the risk-based
capital formulas in the IRB framework is an estimate of the amount of
credit losses above expected credit losses (ECL) over a one-year
horizon that would only be exceeded a small percentage of the time. The
agencies believe that a one-year horizon is
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appropriate because it balances the fact that banking book positions
likely could not be easily or rapidly exited with the possibility that
in many cases a bank can cover credit losses by raising additional
capital should the underlying credit problems manifest themselves
gradually. The nominal confidence level of the IRB risk-based capital
formulas (99.9 percent) means that if all the assumptions in the IRB
supervisory model for credit risk were correct for a bank, there would
be less than a 0.1 percent probability that credit losses at the bank
in any year would exceed the IRB risk-based capital requirement.\5\
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\5\ Banks' internal economic capital models typically focus on
measures of equity capital, whereas the total regulatory capital
measure underlying this proposal includes not only equity capital,
but also certain debt and hybrid instruments, such as subordinated
debt. Thus, the 99.9 percent nominal confidence level embodied in
the IRB framework is not directly comparable to the nominal solvency
standards underpinning banks' economic capital models.
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As noted above, the supervisory model of credit risk underlying the
IRB framework embodies specific assumptions about the economic drivers
of portfolio credit risk at banks. As with any modeling approach, these
assumptions represent simplifications of very complex real-world
phenomena and, at best, are only an approximation of the actual credit
risks at any bank. To the extent these assumptions (described in
greater detail below) do not characterize a given bank precisely, the
actual confidence level implied by the IRB risk-based capital formulas
may exceed or fall short of the framework's nominal 99.9 percent
confidence level.
In combination with other supervisory assumptions and parameters
underlying this proposal, the IRB framework's 99.9 percent nominal
confidence level reflects a judgmental pooling of available
information, including supervisory experience. The framework underlying
this proposal reflects a desire on the part of the agencies to achieve
(i) relative risk-based capital requirements across different assets
that are broadly consistent with maintaining at least an investment
grade rating (for example, at least BBB) on the liabilities funding
those assets, even in periods of economic adversity; and (ii) for the
U.S. banking system as a whole, aggregate minimum regulatory capital
requirements that are not a material reduction from the aggregate
minimum regulatory capital requirements under the general risk-based
capital rules.
A number of important explicit generalizing assumptions and
specific parameters are built into the IRB framework to make the
framework applicable to a range of banks and to obtain tractable
information for calculating risk-based capital requirements. Chief
among the assumptions embodied in the IRB framework are: (i)
Assumptions that a bank's credit portfolio is infinitely granular; (ii)
assumptions that loan defaults at a bank are driven by a single,
systematic risk factor; (iii) assumptions that systematic and non-
systematic risk factors are log-normal random variables; and (iv)
assumptions regarding correlations among credit losses on various types
of assets.
The specific risk-based capital formulas in this proposed rule
require the bank to estimate certain risk parameters for its wholesale
and retail exposures, which the bank may do using a variety of
techniques. These risk parameters are probability of default (PD),
expected loss given default (ELGD), loss given default (LGD), exposure
at default (EAD), and, for wholesale exposures, effective remaining
maturity (M). The risk-based capital formulas into which the estimated
risk parameters are inserted are simpler than the economic capital
methodologies typically employed by banks (which often require complex
computer simulations). In particular, an important property of the IRB
risk-based capital formulas is portfolio invariance. That is, the risk-
based capital requirement for a particular exposure generally does not
depend on the other exposures held by the bank. Like the general risk-
based capital rules, the total credit risk capital requirement for a
bank's wholesale and retail exposures is the sum of the credit risk
capital requirements on individual wholesale exposures and retail
exposures.
The IRB risk-based capital formulas contain supervisory asset value
correlation (AVC) factors, which have a significant impact on the
capital requirements generated by the formulas. The AVC assigned to a
given portfolio of exposures is an estimate of the degree to which any
unanticipated changes in the financial conditions of the underlying
obligors of the exposures are correlated (that is, would likely move up
and down together). High correlation of exposures in a period of
economic downturn conditions is an area of supervisory concern. For a
portfolio of exposures having the same risk parameters, a larger AVC
implies less diversification within the portfolio, greater overall
systematic risk, and, hence, a higher risk-based capital
requirement.\6\ For example, a 15 percent AVC for a portfolio of
residential mortgage exposures would result in a lower risk-based
capital requirement than a 20 percent AVC and a higher risk-based
capital requirement than a 10 percent AVC.
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\6\ See Explanatory Note.
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The AVCs that appear in the IRB risk-based capital formulas for
wholesale exposures decline with increasing PD; that is, the IRB risk-
based capital formulas generally imply that a group of low-PD wholesale
exposures are more correlated than a group of high-PD wholesale
exposures. Thus, under the proposed rule, a low-PD wholesale exposure
would have a higher relative risk-based capital requirement than that
implied by its PD were the AVC in the IRB risk-based capital formulas
for wholesale exposures fixed rather than a function of PD. This
inverse relationship between PD and AVC for wholesale exposures is
broadly consistent with empirical research undertaken by G10
supervisors and moderates the sensitivity of IRB risk-based capital
requirements for wholesale exposures to the economic cycle. Question 1:
The agencies seek comment on and empirical analysis of the
appropriateness of the proposed rule's AVCs for wholesale exposures in
general and for various types of wholesale exposures (for example,
commercial real estate exposures).
The AVCs included in the IRB risk-based capital formulas for retail
exposures also reflect a combination of supervisory judgment and
empirical evidence.\7\ However, the historical data available for
estimating these correlations was more limited than was the case with
wholesale exposures, particularly for non-mortgage retail exposures. As
a result, supervisory judgment played a greater role. Moreover, the
flat 15 percent AVC for residential mortgage exposures is based largely
on empirical analysis of traditional long-term, fixed-rate mortgages.
Question 2: The agencies seek comment on and empirical analysis of the
appropriateness and risk sensitivity of the proposed rule's AVC for
residential mortgage exposures--not only for long-term, fixed-rate
mortgages, but also for adjustable-rate mortgages, home equity lines of
credit, and other mortgage products--and for other retail portfolios.
---------------------------------------------------------------------------
\7\ See Explanatory Note, section 5.3.
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Another important conceptual element of the IRB framework concerns
the treatment of EL. The ANPR generally would have required banks to
hold capital against the measured amount of UL plus EL over a one-year
horizon, except in the limited instance of credit card exposures where
future
[[Page 55835]]
margin income (FMI) was allowed to offset EL. The ANPR treatment also
would have maintained the existing definition of regulatory capital,
which includes the allowance for loan and lease losses (ALLL) in tier 2
capital up to a limit equal to 1.25 percent of risk-weighted assets.
The ANPR requested comment on the proposed treatment of EL. Many
commenters on the ANPR objected to this treatment on conceptual
grounds, arguing that capital is not the appropriate mechanism for
covering EL. In response to this feedback, the agencies sought and
obtained changes to the BCBS's proposals in this area.
The agencies supported the BCBS's proposal, announced in October
2003, to remove ECL (as defined below) from the risk-weighted assets
calculation. This NPR, consistent with the New Accord, removes ECL from
the risk-weighted assets calculation but requires a bank to compare its
ECL to its eligible credit reserves (as defined below). If a bank's ECL
exceeds its eligible credit reserves, the bank must deduct the excess
ECL amount 50 percent from tier 1 capital and 50 percent from tier 2
capital. If a bank's eligible credit reserves exceed its ECL, the bank
would be able to include the excess eligible credit reserves amount in
tier 2 capital, up to 0.6 percent of the bank's credit risk-weighted
assets. This treatment is intended to maintain a capital incentive to
reserve prudently and seeks to ensure that ECL over a one-year horizon
is covered either by reserves or capital. This treatment also
recognizes that prudent reserving that considers probable losses over
the life of a loan may result in a bank holding reserves in excess of
ECL measured with a one-year horizon. The BCBS calibrated the proposed
0.6 percent limit on inclusion of excess reserves in tier 2 capital to
be approximately as restrictive as the existing cap on the inclusion of
ALLL under the general risk-based capital rules, based on data obtained
in the BCBS's Third Quantitative Impact Study (QIS-3).\8\ Question 3:
The agencies seek comment and supporting data on the appropriateness of
this limit.
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\8\ BCBS, ``QIS 3: Third Quantitative Impact Study,'' May 2003.
---------------------------------------------------------------------------
The agencies are aware that certain banks believe that FMI should
be eligible to cover ECL for the purposes of such a calculation, while
other banks have asserted that, for certain business lines, prudential
reserving practices do not involve setting reserves at levels
consistent with ECL over a horizon as long as one year. The agencies
nevertheless believe that the proposed approach is appropriate because
banks should receive risk-based capital benefits only for the most
highly reliable ECL offsets.
The combined impact of these changes in the treatment of ECL and
reserves will depend on the reserving practices of individual banks.
Nevertheless, if other factors are equal, the removal of ECL from the
calculation of risk-weighted assets will result in a lower amount of
risk-weighted assets than the proposals in the ANPR. However, the
impact on risk-based capital ratios should be partially offset by
related changes to the numerators of the risk-based capital ratios--
specifically, (i) the ALLL will be allowed in tier 2 capital up to
certain limits only to the extent that it and certain other reserves
exceed ECL, and (ii) if ECL exceeds reserves, the reserve shortfall
must be deducted 50 percent from tier 1 capital and 50 percent from
tier 2 capital.
Using data from QIS-3, the BCBS conducted an analysis of the risk-
based capital requirements that would be generated under the New
Accord, taking into account the aggregate effect of ECL-related changes
to both the numerator and the denominator of the risk-based capital
ratios. The BCBS concluded that to offset these changes relative to the
credit risk-based capital requirements of the Proposed New Accord, it
might be necessary under the New Accord to apply a ``scaling factor''
(multiplier) to credit risk-weighted assets. The BCBS, in the New
Accord, indicated that the best estimate of the scaling factor using
QIS-3 data adjusted for the EL-UL decisions was 1.06. The BCBS noted
that a final determination of any scaling factor would be reconsidered
prior to full implementation of the new framework. The agencies are
proposing a multiplier of 1.06 at this time, consistent with the New
Accord.
The agencies note that a 1.06 multiplier should be viewed as a
placeholder. The BCBS is expected to revisit the determination of a
scaling factor based on the results of the latest international QIS
(QIS-5, which was not conducted in the United States).\9\ The agencies
will consider the BCBS's determination, as well as other factors
including the most recent QIS conducted in the United States (QIS-4,
which is described below),\10\ in determining a multiplier for the
final rule. As the agencies gain more experience with the proposed
advanced approaches, the agencies will revisit the scaling factor along
with other calibration issues identified during the parallel run and
transitional floor periods (described below) and make changes to the
rule as necessary. While a scaling factor is one way to ensure that
regulatory capital is maintained at a certain level, particularly in
the short- to medium-term, the agencies also may address calibration
issues through modifications to the underlying IRB risk-based capital
formulas.
---------------------------------------------------------------------------
\9\ See http://www.bis.org/bcbs/qis/qis5.htm.
\10\ See ``Summary Findings of the Fourth Quantitative Impact
Study,'' February 24, 2006.
---------------------------------------------------------------------------
2. The AMA for Operational Risk
The proposed rule also includes the AMA for determining risk-based
capital requirements for operational risk. Under the proposed rule,
operational risk is defined as the risk of loss resulting from
inadequate or failed internal processes, people, and systems or from
external events. This definition of operational risk includes legal
risk--which is the risk of loss (including litigation costs,
settlements, and regulatory fines) resulting from the failure of the
bank to comply with laws, regulations, prudent ethical standards, and
contractual obligations in any aspect of the bank's business--but
excludes strategic and reputational risks.
Under the AMA, a bank would use its internal operational risk
management systems and processes to assess its exposure to operational
risk. Given the complexities involved in measuring operational risk,
the AMA provides banks with substantial flexibility and, therefore,
does not require a bank to use specific methodologies or distributional
assumptions. Nevertheless, a bank using the AMA must demonstrate to the
satisfaction of its primary Federal supervisor that its systems for
managing and measuring operational risk meet established standards,
including producing an estimate of operational risk exposure that meets
a 1-year, 99.9th percentile soundness standard. A bank's estimate of
operational risk exposure includes both expected operational loss (EOL)
and unexpected operational loss (UOL) and forms the basis of the bank's
risk-based capital requirement for operational risk.
The AMA allows a bank to base its risk-based capital requirement
for operational risk on UOL alone if the bank can demonstrate to the
satisfaction of its primary Federal supervisor that the bank has
eligible operational risk offsets, such as certain operational risk
reserves, that equal or exceed the bank's EOL. To the extent that
eligible operational risk offsets are less than EOL, the bank's risk-
based capital requirement for operational risk must incorporate the
shortfall.
[[Page 55836]]
C. Overview of Proposed Rule
The proposed rule maintains the general risk-based capital rules'
minimum tier 1 risk-based capital ratio of 4.0 percent and total risk-
based capital ratio of 8.0 percent. The components of tier 1 and total
capital are also generally the same, with a few adjustments described
in more detail below. The primary difference between the general risk-
based capital rules and the proposed rule is the methodologies used for
calculating risk-weighted assets. Banks applying the proposed rule
generally would use their internal risk measurement systems to
calculate the inputs for determining the risk-weighted asset amounts
for (i) general credit risk (including wholesale and retail exposures);
(ii) securitization exposures; (iii) equity exposures; and (iv)
operational risk. In certain cases, however, external ratings or
supervisory risk weights would be used to determine risk-weighted asset
amounts. Each of these areas is discussed below.
Banks using the proposed rule also would be subject to supervisory
review of their capital adequacy (Pillar 2) and certain public
disclosure requirements to foster transparency and market discipline
(Pillar 3). In addition, each bank using the advanced approaches would
continue to be subject to the tier 1 leverage ratio requirement, and
each depository institution (DI) (as defined in section 3 of the
Federal Deposit Insurance Act (12 U.S.C. 1813)) using the advanced
approaches would continue to be subject to the prompt corrective action
(PCA) thresholds. Those banks subject to the MRA also would continue to
be subject to the MRA.
Under the proposed rule, a bank must identify whether each of its
on- and off-balance sheet exposures is a wholesale, retail,
securitization, or equity exposure. Assets that are not defined by any
exposure category (and certain immaterial portfolios of exposures)
generally would be assigned risk-weighted asset amounts equal to their
carrying value (for on-balance sheet exposures) or notional amount (for
off-balance sheet exposures).
Wholesale exposures under the proposed rule include most credit
exposures to companies and governmental entities. For each wholesale
exposure, a bank would assign five quantitative risk parameters: PD
(which is stated as a percentage and measures the likelihood that an
obligor will default over a 1-year horizon); ELGD (which is stated as a
percentage and is an estimate of the economic loss rate if a default
occurs); LGD (which is stated as a percentage and is an estimate of the
economic loss rate if a default occurs during economic downturn
conditions); EAD (which is measured in dollars and is an estimate of
the amount that would be owed to the bank at the time of default); and
M (which is measured in years and reflects the effective remaining
maturity of the exposure). Banks would be able to factor into their
risk parameter estimates the risk mitigating impact of collateral,
credit derivatives, and guarantees that meet certain criteria. Banks
would input the risk parameters for each wholesale exposure into an IRB
risk-based capital formula to determine the risk-based capital
requirement for the exposure.
Retail exposures under the proposed rule include most credit
exposures to individuals and small businesses that are managed as part
of a segment of exposures with similar risk characteristics, not on an
individual-exposure basis. A bank would classify each of its retail
exposures into one of three retail subcategories--residential mortgage
exposures, qualifying revolving exposures (QREs) (for example, credit
cards and overdraft lines), and other retail exposures. Within these
three subcategories, the bank would group exposures into segments with
similar risk characteristics. The bank would then assign the risk
parameters PD, ELGD, LGD, and EAD to each retail segment. The bank
would be able to take into account the risk mitigating impact of
collateral and guarantees in the segmentation process and in the
assignment of risk parameters to retail segments. Like wholesale
exposures, the risk parameters for each retail segment would be used as
inputs into an IRB risk-based capital formula to determine the risk-
based capital requirement for the segment. Question 4: The agencies
seek comment on the use of a segment-based approach rather than an
exposure-by-exposure approach for retail exposures.
For securitization exposures, the bank would apply one of three
general approaches, subject to various conditions and qualifying
criteria: the Ratings-Based Approach (RBA), which uses external ratings
to risk-weight exposures; an Internal Assessment Approach (IAA), which
uses internal ratings to risk-weight exposures to asset-backed
commercial paper programs (ABCP programs); or the Supervisory Formula
Approach (SFA). Securitization exposures in the form of gain-on-sale or
credit-enhancing interest-only strips (CEIOs)\11\ and securitization
exposures that do not qualify for the RBA, the IAA, or the SFA would be
deducted from regulatory capital.
---------------------------------------------------------------------------
\11\ A CEIO is an on-balance-sheet asset that (i) represents the
contractual right to receive some or all of the interest and no more
than a minimal amount of principal due on the underlying exposures
of a securitization and (ii) exposes the holder to credit risk
directly or indirectly associated with the underlying exposures that
exceeds its pro rata claim on the underlying exposures whether
through subordination provisions or other credit-enhancement
techniques.
---------------------------------------------------------------------------
Banks would be able to use an internal models approach (IMA) for
determining risk-based capital requirements for equity exposures,
subject to certain qualifying criteria and floors. If a bank does not
have a qualifying internal model for equity exposures, or chooses not
to use such a model, the bank must apply a simple risk weight approach
(SRWA) in which publicly traded equity exposures would have a 300
percent risk weight and non-publicly traded equity exposures would have
a 400 percent risk weight. Under both the IMA and the SRWA, equity
exposures to certain entities or made pursuant to certain statutory
authorities would be subject to a 0 to 100 percent risk weight.
Banks would have to develop qualifying AMA systems to determine
risk-based capital requirements for operational risk. Under the AMA, a
bank would use its own methodology to identify operational loss events,
measure its exposure to operational risk, and assess a risk-based
capital requirement for operational risk.
Under the proposed rule, a bank would calculate its risk-based
capital ratios by first converting any dollar risk-based capital
requirements for exposures produced by the IRB risk-based capital
formulas into risk-weighted asset amounts by multiplying the capital
requirements by 12.5 (the inverse of the overall 8.0 percent risk-based
capital requirement). After determining the risk-weighted asset amounts
for credit risk and operational risk, a bank would sum these amounts
and then subtract any allocated transfer risk reserves and excess
eligible credit reserves not included in tier 2 capital (defined below)
to determine total risk-weighted assets. The bank would then calculate
its risk-based capital ratios by dividing its tier 1 capital and total
qualifying capital by the total risk-weighted assets amount.
The proposed rule contains specific public disclosure requirements
to provide important information to market participants on the capital
structure, risk exposures, risk assessment processes, and, hence, the
[[Page 55837]]
capital adequacy of a bank. The public disclosure requirements would
apply only to the DI or bank holding company representing the top
consolidated level of the banking group that is subject to the advanced
approaches. In addition, the agencies are also publishing today
proposals to require certain disclosures from subsidiary DIs in the
banking group through the supervisory reporting process. The agencies
believe that the reporting of key risk parameter estimates for each DI
applying the advanced approaches will provide the primary Federal
supervisor of the DI and other relevant supervisors with important data
for assessing the reasonableness and accuracy of the institution's
calculation of its risk-based capital requirements under this proposal
and the adequacy of the institution's capital in relation to its risks.
Some of the proposed supervisory reports would be publicly available
(for example, on the Call Report or Thrift Financial Report), and
others would be confidential disclosures to the agencies to augment the
supervisory process.
D. Structure of Proposed Rule
The agencies are considering implementing a comprehensive
regulatory framework for the advanced approaches in which each agency
would have an advanced approaches regulation or appendix that sets
forth (i) the elements of tier 1 and tier 2 capital and associated
adjustments to the risk-based capital ratio numerator, (ii) the
qualification requirements for using the advanced approaches, and (iii)
the details of the advanced approaches. For proposal purposes, the
agencies are issuing a single proposed regulatory text for comment.
Unless otherwise indicated, the term ``bank'' in the regulatory text
includes banks, savings associations, and bank holding companies
(BHCs). The term ``[AGENCY]'' in the regulatory text refers to the
primary Federal supervisor of the bank applying the rule. Areas where
the regulatory text would differ by agency--for example, provisions
that would only apply to savings associations or to BHCs--are generally
indicated in appropriate places.
In this proposed rule, the agencies are not restating the elements
of tier 1 and tier 2 capital, which would generally remain the same as
under the general risk-based capital rules. Adjustments to the risk-
based capital ratio numerators specific to banks applying the advanced
approaches are in part II of the proposed rule and explained in greater
detail in section IV of this preamble. The OCC, Board, and FDIC also
are proposing to incorporate their existing market risk rules by cross-
reference and are proposing modifications to the market risk rules in a
separate NPR issued concurrently.\12\ The OTS is proposing its own
market risk rule, including the proposed modifications, as a part of
that separate NPR. In addition, the agencies may need to make
additional conforming amendments to certain of their regulations that
use tier 1 or total qualifying capital or the risk-based capital ratios
for various purposes.
---------------------------------------------------------------------------
\12\ See elsewhere in today's issue of the Federal Register.
---------------------------------------------------------------------------
The proposed rule is structured in eight broad parts. Part I
identifies criteria for determining which banks are subject to the
rule, provides key definitions, and sets forth the minimum risk-based
capital ratios. Part II describes the adjustments to the numerator of
the risk-based capital ratios for banks using the advanced approaches.
Part III describes the qualification process and provides qualification
requirements for obtaining supervisory approval for use of the advanced
approaches. This part incorporates critical elements of supervisory
oversight of capital adequacy (Pillar 2).
Parts IV through VII address the calculation of risk-weighted
assets. Part IV provides the risk-weighted assets calculation
methodologies for wholesale and retail exposures; on-balance-sheet
assets that do not meet the regulatory definition of a wholesale,
retail, securitization, or equity exposure; and certain immaterial
portfolios of credit exposures. This part also describes the risk-based
capital treatment for over-the-counter (OTC) derivative contracts,
repo-style transactions, and eligible margin loans. In addition, this
part describes the methodology for reflecting eligible credit risk
mitigation techniques in risk-weighted assets for wholesale and retail
exposures. Furthermore, this part sets forth the risk-based capital
requirements for failed and unsettled securities, commodities, and
foreign exchange transactions.
Part V identifies operating criteria for recognizing risk
transference in the securitization context and outlines the approaches
for calculating risk-weighted assets for securitization exposures. Part
VI describes the approaches for calculating risk-weighted assets for
equity exposures. Part VII describes the calculation of risk-weighted
assets for operational risk. Finally, Part VIII provides public
disclosure requirements for banks employing the advanced approaches
(Pillar 3).
The structure of the preamble generally follows the structure of
the proposed regulatory text. Definitions, however, are discussed in
the portions of the preamble where they are most relevant.
E. Quantitative Impact Study 4 and Overall Capital Objectives
1. Quantitative Impact Study 4
After the BCBS published the New Accord, the agencies conducted the
additional quantitative impact study referenced above, QIS-4, in the
fall and winter of 2004-2005, to better understand the potential impact
of the proposed framework on the risk-based capital requirements for
individual U.S. banks and U.S. banks as a whole. The results showed a
substantial dollar-weighted average decline and variation in risk-based
capital requirements across the 26 participating U.S. banks and their
portfolios.\13\ In an April 2005 press release,\14\ the agencies
expressed their concern about the magnitude of the drop in QIS-4 risk-
based capital requirements and the dispersion of those requirements and
decided to undertake further analysis.
---------------------------------------------------------------------------
\13\ Since neither an NPR and associated supervisory guidance
nor final regulations implementing a Basel II-based framework had
been issued in the United States at the time of data collection, all
QIS-4 results relating to the U.S. implementation of Basel II are
based on the description of the framework contained in the QIS-4
instructions. These instructions differed from the framework issued
by the BCBS in June 2004 in several respects. For example, the QIS-4
articulation of the Basel II framework does not include the 1.06
scaling factor. The QIS-4 instructions are available at http://www.ffiec.gov/qis4.
\14\ See ``Banking Agencies to Perform Additional Analysis
Before Issuing Notice of Proposed Rulemaking Related to Basel II,''
Apr. 29, 2005.
---------------------------------------------------------------------------
The QIS-4 analysis indicated a dollar-weighted average reduction of
15.5 percent in risk-based capital requirements at participating banks
when moving from the current Basel I-based framework to a Basel II-
based framework.\15\ Table A provides a numerical summary of the QIS-4
results, in total and by portfolio, aggregated across all QIS-4
participants.\16\ The first column shows
[[Page 55838]]
changes in dollar-weighted average minimum required capital (MRC) both
by portfolio and overall, as well as in dollar-weighted average overall
effective MRC. Column 2 shows the relative contribution of each
portfolio to the overall dollar-weighted average decline of 12.5
percent in MRC, representing both the increase/decrease and relative
size of each portfolio. The table also shows (column 3) that risk-based
capital requirements declined by more than 26 percent in half the banks
in the study. Most portfolios showed double-digit declines in risk-
based capital requirements for over half the banks, with the exception
of credit cards. It should be noted that column 3 gives every
participating bank equal weight. Column 4 shows the analogous weighted
median change, using total exposures as weights.
---------------------------------------------------------------------------
\15\ The Basel II framework on which QIS-4 is based uses a UL-
only approach (even though EL requirements were included in QIS-4).
But the current Basel I risk-based capital requirements use a UL+EL
approach. Therefore, in order to compare the Basel II results from
QIS-4 with the current Basel I requirements, the EL requirements
from QIS-4 had to be added to the UL capital requirements from QIS-
4.
\16\ In the table, ``Minimum required capital'' (MRC) refers to
the total risk-based capital requirement before incorporating the
impact of reserves. ``Effective MRC'' is equal to MRC adjusted for
the impact of reserves. As noted above, under the Basel II
framework, a shortfall in reserves generally increases the total
risk-based capital requirement and a surplus in reserves generally
reduces the total risk-based capital requirement, though not with
equal impact.
[GRAPHIC] [TIFF OMITTED] TP25SE06.076
QIS-4 results (not shown in Table A) also suggested that tier 1
risk-based capital requirements under a Basel II-based framework would
be lower for many banks than they are under the general risk-based
capital rules, in part reflecting the move to a UL-only risk-based
capital requirement. Tier 1 risk-based capital requirements declined by
22 percent in the aggregate. The unweighted median indicates that half
of the participating banks reported reductions in tier 1 risk-based
capital requirements of over 31 percent. The MRC calculations do not
take into account the impact of the tier 1 leverage ratio requirement.
Were such results produced under a fully implemented Basel II-based
risk-based capital regime, the existing tier 1 leverage ratio
requirement could be a more important constraint than it is currently.
Evidence from some of the follow-up analysis also illustrated that
similar loan products at different banks may have resulted in very
different risk-based capital requirements. Analysis
[[Page 55839]]
determined that this dispersion in capital requirements not only
reflected differences in actual risk or portfolio composition, but also
reflected differences in the banks' estimated risk parameters for
similar exposures.
Although concerns with dispersion might be remedied to some degree
with refinements to internal bank risk measurement and management
systems and through the rulemaking process, the agencies also note that
some of the dispersion encountered in the QIS-4 exercise is a
reflection of the flexibility in methods to quantify the risk
parameters that may be allowed under implementation of the proposed
framework.
The agencies intend to conduct other analyses of the impact of the
Basel II framework during both the parallel run and transitional floor
periods. These analyses will look at both the impact of the Basel II
framework and the preparedness of banks to compute risk-based capital
requirements in a manner consistent with the Basel II framework.
2. Overall Capital Objectives
The ANPR stated: ``The Agencies do not expect the implementation of
the New Accord to result in a significant decrease in aggregate capital
requirements for the U.S. banking system. Individual banking
organizations may, however, face increases or decreases in their
minimum risk-based capital requirements because the New Accord is more
risk sensitive than the 1988 Accord and the Agencies' existing risk-
based capital rules (general risk-based capital rules).'' \17\ The ANPR
was in this respect consistent with statements made by the BCBS in its
series of Basel II consultative papers and its final text of the New
Accord, in which the BCBS stated as an objective broad maintenance of
the overall level of risk-based capital requirements while allowing
some incentives for banks to adopt the advanced approaches.
---------------------------------------------------------------------------
\17\ 68 FR 45900, 45902 (Aug. 4, 2003).
---------------------------------------------------------------------------
The agencies remain committed to these objectives. Were the QIS-4
results just described produced under an up-and-running risk-based
capital regime, the risk-based capital requirements generated under the
framework would not meet the objectives described in the ANPR, and thus
would be considered unacceptable.
When considering QIS-4 results and their implications, it is
important to recognize that banking organizations participated in QIS-4
on a best-efforts basis. The agencies had not qualified any of the
participants to use the Basel II framework and had not conducted any
formal supervisory review of their progress toward meeting the Basel II
qualification requirements. In addition, the risk measurement and
management systems of the QIS-4 participants, as indicated by the QIS-4
exercise, did not yet meet the Basel II qualification requirements
outlined in this proposed rule.
As banks work with their supervisors to refine their risk
measurement and management systems, it will become easier to determine
the actual quantitative impact of the advanced approaches. The agencies
have decided, therefore, not to recalibrate the framework at the
present time based on QIS-4 results, but to await further experience
with more fully developed bank risk measurement and management systems.
If there is a material reduction in aggregate minimum regulatory
capital requirements upon implementation of Basel II-based rules, the
agencies will propose regulatory changes or adjustments during the
transitional floor periods. In this context, materiality will depend on
a number of factors, including the size, source, and nature of any
reduction; the risk profiles of banks authorized to use Basel II-based
rules; and other considerations relevant to the maintenance of a safe
and sound banking system. In any event, the agencies will view a 10
percent or greater decline in aggregate minimum required risk-based
capital (without reference to the effects of the transitional floors
described in a later section of this preamble), compared to minimum
required risk-based capital as determined under the existing rules, as
a material reduction warranting modifications to the supervisory risk
functions or other aspects of this framework.
The agencies are, in short, identifying a numerical benchmark for
evaluating and responding to capital outcomes during the parallel run
and transitional floor periods that do not comport with the overall
capital objectives outlined in the ANPR. At the end of the transitional
floor periods, the agencies would re-evaluate the consistency of the
framework, as (possibly) revised during the transitional floor periods,
with the capital goals outlined in the ANPR and with the maintenance of
broad competitive parity between banks adopting the framework and other
banks, and would be prepared to make further changes to the framework
if warranted. Question 5: The agencies seek comment on this approach to
ensuring that overall capital objectives are achieved.
The agencies also noted above that tier 1 capital requirements
reported in QIS-4 declined substantially more than did total capital
requirements. The agencies have long placed special emphasis on the
importance of tier 1 capital in maintaining bank safety and soundness
because of its ability to absorb losses on a going concern basis. The
agencies will continue to monitor the trend in tier 1 capital
requirements during the parallel run and transitional floor periods and
will take appropriate action if reductions in tier 1 capital
requirements are inconsistent with the agencies' overall capital goals.
Similar to the attention the agencies will give to overall risk-
based capital requirements for the U.S. banking system, the agencies
will carefully consider during the transitional floor periods whether
dispersion in risk-based capital results across banks and portfolios
appropriately reflects differences in risk. A conclusion by the
agencies that dispersion in risk-based capital requirements does not
appropriately reflect differences in risk could be another possible
basis for proposing regulatory adjustments or refinements during the
transitional floor periods.
It should also be noted that given the bifurcated regulatory
capital framework that would result from the adoption of this rule,
issues related to overall capital may be inextricably linked to the
competitive issues discussed elsewhere in this document. The agencies
indicated in the ANPR that if the competitive effects of differential
capital requirements were deemed significant, ``the Agencies would need
to consider potential ways to address those effects while continuing to
seek the objectives of the current proposal. Alternatives could
potentially include modifications to the proposed approaches, as well
as fundamentally different approaches.'' \18\ In this regard, the
agencies view the parallel run and transitional floor periods as a
trial of the new framework under controlled conditions. While the
agencies hope and expect that regulatory changes proposed during those
years would be in the nature of adjustments made within the framework
described in this proposed rule, more fundamental changes cannot be
ruled out if warranted based on future experience or comments received
on this proposal.
---------------------------------------------------------------------------
\18\ 68 FR 45900, 45905 (August 4, 2003).
---------------------------------------------------------------------------
The agencies reiterate that, especially in light of the QIS-4
results, retention of the tier 1 leverage ratio and other existing
prudential safeguards (for example, PCA) is critical for the
[[Page 55840]]
preservation of a safe and sound regulatory capital framework. In
particular, the leverage ratio is a straightforward and tangible
measure of solvency and serves as a needed complement to the risk-
sensitive Basel II framework based on internal bank inputs.
F. Competitive Considerations
A fundamental objective of the New Accord is to strengthen the
soundness and stability of the international banking system while
maintaining sufficient consistency in capital adequacy regulation to
ensure that the New Accord will not be a significant source of
competitive inequity among internationally active banks. The agencies
support this objective and believe that it is crucial to promote
continual advancement of the risk measurement and management practices
of large and internationally active banks. For this reason, the
agencies propose to implement only the advanced approaches of the New
Accord because these approaches utilize the most sophisticated and
risk-sensitive risk measurement and management techniques.
While all banks should work to enhance their risk management
practices, the advanced approaches and the systems required to support
their use may not be appropriate for many banks from a cost-benefit
point of view. For these banks, the agencies believe that, with some
modifications, the general risk-based capital rules are a reasonable
alternative. As discussed in section E.2. above, this proposal's
bifurcated approach to risk-based capital requirements raises difficult
issues and inextricably links competitive considerations with overall
capital issues. One such issue relates to concerns about competitive
inequities between U.S. banks operating under different regulatory
capital regimes. The ANPR cited this concern, and a number of
commenters expressed their belief that in some portfolios competitive
inequities would be worsened under the proposed bifurcated framework.
These commenters expressed the concern that the Proposed New Accord
might place community banks operating under the general risk-based
capital rules at a competitive disadvantage to banks applying the
advanced approaches because the IRB framework would likely result in
lower risk-based capital requirements on some types of exposures, such
as residential mortgage exposures, other retail exposures, and small
business loans.
Some commenters asserted that the application of lower risk-based
capital requirements under the Proposed New Accord would create a
competitive disadvantage for banks operating under the general risk-
based capital rules, which in turn may adversely affect their asset
quality and cost of capital. Other commenters suggested that if the
advanced approaches in the Proposed New Accord are implemented, the
agencies should consider revising their general risk-based capital
rules to enhance risk sensitivity and to mitigate potential competitive
inequities associated with the bifurcated system.
The agencies recognize that the industry has concerns with the
potential competitive inequities associated with a bifurcated risk-
based capital framework. The agencies reaffirm their intention,
expressed in the ANPR, to address competitive issues while continuing
to pursue the objectives of the current proposal. In addition to the
QIS-4 analysis discussed above, the agencies have also researched
discrete topics to further understand where competitive pressures might
arise. As part of their effort to develop a bifurcated risk-based
capital framework that minimizes competitive inequities and is not
disruptive to the banking sector, the agencies issued an Advance Notice
of Proposed Rulemaking (Basel IA ANPR) considering various
modifications to the general risk-based capital rules to improve risk
sensitivity and to reduce potential competitive disparities between
Basel II banks and non-Basel II banks.\19\ The comment period for the
Basel IA ANPR ended on January 18, 2006, and the agencies intend to
consider all comments and issue for public comment a more fully
developed risk-based capital proposal for non-Basel II banks. The
comment period for the non-Basel II proposal is expected to overlap
that of this proposal, allowing commenters to analyze the effects of
the two proposals concurrently.
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\19\ See 70 FR 61068 (Oct. 20, 2005).
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In addition, some commenters expressed concern about competitive
inequities arising from differences in implementation and application
of the New Accord by supervisory authorities in different countries. In
particular, some commenters expressed concern about the different
implementation timetables of various jurisdictions, and differences in
the scope of application in various jurisdictions or in the range of
approaches that different jurisdictions will allow. The BCBS has
established an Accord Implementation Group, comprised of supervisors
from member countries, whose primary objectives are to work through
implementation issues, maintain a constructive dialogue about
implementation processes, and harmonize approaches as much as possible
within the range of national discretion embedded in the New Accord.
While supervisory judgment will play a critical role in the
evaluation of risk measurement and management practices at individual
banks, supervisors are committed to developing protocols and
information-sharing arrangements that should minimize burdens on banks
operating in multiple countries and ensure that supervisory authorities
are implementing the New Accord as consistently as possible. The New
Accord identifies numerous areas where national discretion is
encouraged. This design was intended to enable national supervisors to
implement the methodology, or combination of methodologies, most
appropriate for banks in their jurisdictions. Disparate implementation
decisions are expected, particularly during the transition years. Over
time, the agencies expect that industry and supervisory practices
likely will converge in many areas, thus mitigating differences across
countries. Competitive considerations, both internationally and
domestically, will be monitored and discussed by the agencies on an
ongoing basis. With regard to implementation timing concerns, the
agencies believe that the transitional arrangements described in
section III.A. of this preamble below provide a prudent and reasonable
framework for moving to the advanced approaches. Where international
implementation differences affect an individual bank, the agencies
expect to work with the bank and appropriate national supervisory
authorities for the bank to ensure that implementation proceeds as
smoothly as possible. Question 6: The agencies seek comment on all
potential competitive aspects of this proposal and on any specific
aspects of the proposal that might raise competitive concerns for any
bank or group of banks.
II. Scope
The agencies have identified three groups of banks: (i) Large or
internationally active banks that would be required to adopt the
advanced approaches in the proposed rule (core banks); (ii) banks that
voluntarily decide to adopt the advanced approaches (opt-in banks); and
(iii) banks that do not adopt the advanced approaches (general banks).
Each core and opt-in bank would be required to meet certain
qualification requirements to the satisfaction of its primary Federal
supervisor, in consultation with other
[[Page 55841]]
relevant supervisors, before the bank may use the advanced approaches
for risk-based capital purposes.
Pillar I of the New Accord requires all banks subject to the New
Accord to calculate capital requirements for exposure to both credit
risk and operational risk. The New Accord provides a bank three
approaches to calculate its credit risk capital requirement and three
approaches to calculate its operational risk capital requirement.
Outside the United States, countries that are replacing Basel I with
the New Accord generally have required all banks to comply with the New
Accord, but have provided banks the option of choosing among the New
Accord's various approaches for calculating credit risk and operational
risk capital requirements.\20\ For banks in the United States, the NPR,
like the ANPR, takes a different approach. It would not subject all
U.S. banks to the New Accord, but instead focuses on only the largest
and most internationally active banks. Due to the size and complexity
of these banks, the NPR would require core banks to comply with the
most advanced approaches for calculating credit and operational risk
capital requirements `` that is, the IRB and the AMA. In addition, the
NPR would allow other U.S. banks to ``opt in'' to Basel II-based rules,
but, as with core banks, the only Basel II-based rules available to
U.S. ``opt-in'' banks would be the New Accord's most advanced
approaches.
Question 7: The agencies request comment on whether U.S. banks
subject to the advanced approaches in the proposed rule (that is, core
banks and opt-in banks) should be permitted to use other credit and
operational risk approaches similar to those provided under the New
Accord. With respect to the credit risk capital requirement, the
agencies request comment on whether banks should be provided the option
of using a U.S. version of the so-called ``standardized approach'' of
the New Accord and on the appropriate length of time for such an
option.
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\20\ Despite the options provided in national legislation and
rules, most non-U.S. banks comparable in size and complexity to U.S.
core banks are adopting some form of the advanced approaches. For
example, based on currently available information, the vast majority
of large, internationally-active banks based outside of the United
States plan to employ an internal ratings-based approach in the
calculation of credit risk capital requirements.
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A. Core and Opt-In Banks
A DI is a core bank if it meets either of two independent threshold
criteria: (i) Consolidated total assets of $250 billion or more, as
reported on the most recent year-end regulatory reports; or (ii)
consolidated total on-balance sheet foreign exposure of $10 billion or
more at the most recent year-end. To determine total on-balance sheet
foreign exposure, a bank would sum its adjusted cross-border claims,
local country claims, and cross-border revaluation gains (calculated in
accordance with the Federal Financial Institutions Examination Council
(FFIEC) Country Exposure Report (FFIEC 009)). Adjusted cross-border
claims would equal total cross-border claims less claims with the head
office/guarantor located in another country, plus redistributed
guaranteed amounts to the country of head office/guarantor. A DI also
is a core bank if it is a subsidiary of another DI or BHC that uses the
advanced approaches.
Under the proposed rule, a U.S.-chartered BHC \21\ is a core bank
if the BHC has: (i) Consolidated total assets (excluding assets held by
an insurance underwriting subsidiary) of $250 billion or more, as
reported on the most recent year-end regulatory reports; (ii)
consolidated total on-balance sheet foreign exposure of $10 billion or
more at the most recent year-end; or (iii) a subsidiary DI that is a
core bank or opt-in bank. Currently 11 top-tier banking organizations
meet these criteria. The agencies note that, using this approach to
define whether a BHC is a core bank, it is possible that no single DI
under a BHC would meet the threshold criteria, but that all of the
BHC's subsidiary DIs would be core banks.
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\21\ OTS does not currently impose any explicit capital
requirements on savings and loan holding companies and does not
propose to apply the Basel II proposal to these holding companies.
---------------------------------------------------------------------------
The proposed BHC consolidated asset threshold is different from the
threshold in the ANPR, which applied to the total consolidated DI
assets of a BHC. The proposed shift to total consolidated assets
(excluding assets held by an insurance underwriting subsidiary)
recognizes that BHCs can hold similar assets within and outside of DIs
and reduces potential incentives to structure BHC assets and activities
to arbitrage capital regulations. The proposed rule excludes assets
held in an insurance underwriting subsidiary of a BHC because the New
Accord was not designed to address insurance company exposures.
Question 8A: The Board seeks comment on the proposed BHC consolidated
non-insurance assets threshold relative to the consolidated DI assets
threshold in the ANPR.
A bank that is subject to the proposed rule either as a core bank
or as an opt-in bank would be required to apply the rule unless its
primary Federal supervisor determines in writing that application of
the rule is not appropriate in light of the bank's asset size, level of
complexity, risk profile, or scope of operations. Question 8B: The
agencies seek comment on the proposed scope of application. In
particular, the agencies seek comment on the regulatory burden of a
framework that requires the advanced approaches to be implemented by
each subsidiary DI of a BHC or bank that uses the advanced approaches.
B. U.S. DI Subsidiaries of Foreign Banks
Any U.S.-chartered DI that is a subsidiary of a foreign banking
organization is subject to the U.S. regulatory capital requirements
applied to domestically-owned U.S. DIs. Thus, if the U.S. DI subsidiary
of a foreign banking organization meets any of the threshold criteria,
it would be a core bank and would be subject to the advanced
approaches. If it does not meet any of the criteria, the U.S. DI may
remain a general bank or may opt-in to the advanced approaches, subject
to the same qualification process and requirements as a domestically-
owned U.S. DI. A top-tier U.S. BHC, and its subsidiary DIs, that is
owned by a foreign banking organization also would be subject to the
same threshold levels for core bank determination as would a top-tier
BHC that is not owned by a foreign banking organization. A U.S. BHC
that meets the conditions in Federal Reserve SR letter 01-01\22\ and is
a core bank would not be required to meet the minimum capital ratios in
the Board's capital adequacy guidelines, although it would be required
to adopt the advanced approaches, compute and report its capital ratios
in accordance with the advanced approaches, and make the required
public and regulatory disclosures.
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\22\ SR 01-01, ``Application of the Board's Capital Adequacy
Guidelines to Bank Holding Companies Owned by Foreign Banking
Organizations,'' January 5, 2001.
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A DI subsidiary of such a U.S. BHC would be a core bank and would
be required to adopt the advanced approaches (unless specifically
exempted from the advanced approaches by its primary Federal
supervisor) and meet the minimum capital ratio requirements. In
addition, the Board retains its supervisory authority to require any
BHC, including a U.S. BHC owned or controlled by a foreign banking
organization that is or is treated as a financial holding company
(FHC), to maintain capital levels above
[[Page 55842]]
the regulatory minimums. Question 9: The agencies seek comment on the
application of the proposed rule to DI subsidiaries of a U.S. BHC that
meets the conditions in Federal Reserve SR letter 01-01 and on the
principle of national treatment in this context.
C. Reservation of Authority
The proposed rule would restate the authority of a bank's primary
Federal supervisor to require the bank to hold an overall amount of
capital greater than would otherwise be required under the rule if the
agency determines that the bank's risk-based capital requirements under
the rule are not commensurate with the bank's credit, market,
operational, or other risks. In addition, the agencies anticipate that
there may be instances when the proposed rule generates a risk-weighted
asset amount for specific exposures that is not commensurate with the
risks posed by such exposures. In these cases, under the proposed rule,
the bank's primary Federal supervisor would retain the authority to
require the bank to use a different risk-weighted asset amount for the
exposures or to use different risk parameters (for wholesale or retail
exposures) or model assumptions (for modeled equity or securitization
exposures) than those required in the proposed rule when calculating
the risk-weighted asset amount for those exposures. Similarly, the
proposed rule would provide authority for a bank's primary Federal
supervisor to require the bank to assign a different risk-weighted
asset amount for operational risk, to change elements of its
operational risk analytical framework (including distributional and
dependence assumptions), or to make other changes to the bank's
operational risk management processes, data and assessment systems, or
quantification systems if the supervisor finds that the risk-weighted
asset amount for operational risk produced by the bank under the rule
is not commensurate with the operational risks of the bank. Any agency
that exercises this reservation of authority would notify each of the
other agencies of its determination.
III. Qualification
A. The Qualification Process
1. In General
Supervisory qualification to use the advanced approaches is a
continuous and iterative process that begins when a bank's board of
directors adopts an implementation plan and continues as the bank
operates under the advanced approaches. Before a bank may use the
advanced approaches for risk-based capital purposes, it must develop
and adopt a written implementation plan, establish and maintain a
comprehensive and sound planning and governance process to oversee the
implementation efforts described in the plan, demonstrate to its
primary Federal supervisor that it meets the qualification requirements
in section 22 of the proposed rule, and complete a satisfactory
``parallel run'' (discussed below). A bank's primary Federal supervisor
would be responsible, after consultation with other relevant
supervisors, for evaluating the bank's initial and ongoing compliance
with the qualification requirements for the advanced approaches.
The agencies will jointly issue supervisory guidance describing
agency expectations for wholesale, retail, securitization, and equity
exposures, as well as for operational risk.\23\ The agencies recognize
that a consistent and transparent process to oversee implementation of
the advanced approaches is crucial, and will consult with each other on
significant issues raised during the implementation process.
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\23\ The agencies have issued for public comment draft
supervisory guidance on corporate and retail exposures and
operational risk. See 68 FR 45949 (Aug. 4, 2003); 69 FR 62748 (Oct.
27, 2004).
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Under the proposed rule, a bank preparing to implement the advanced
approaches must adopt a written implementation plan, approved by its
board of directors, describing in detail how the bank complies, or
intends to comply, with the qualification requirements. A core bank
must adopt a plan no later than six months after it meets a threshold
criterion in section 1(b)(1) of the proposed rule. If a bank meets a
threshold criterion on the effective date of the final rule, the bank
would have to adopt a plan within six months of the effective date.
Banks that do not meet a threshold criterion, but are nearing any
criterion by direct growth or merger, would be expected to engage in
ongoing dialogue with their primary Federal supervisor regarding
implementation strategies to ensure their readiness to adopt the
advanced approaches when a threshold criterion is reached. An opt-in
bank may adopt an implementation plan at any time, but must adopt an
implementation plan and notify its primary Federal supervisor in
writing at least twelve months before it proposes to begin the first
floor period (as discussed later in this section of the preamble).
In developing an implementation plan, a bank must assess its
current state of readiness relative to the qualification requirements
in this proposed rule and related supervisory guidance. This assessment
would include a gap analysis that identifies where additional work is
needed and a remediation or action plan that clearly sets forth how the
bank intends to fill the gaps it has identified. The implementation
plan must comprehensively address the qualification requirements for
the bank and each of its consolidated subsidiaries (U.S. and foreign-
based) with respect to all portfolios and exposures of the bank and
each of its consolidated subsidiaries. The implementation plan must
justify and support any proposed temporary or permanent exclusion of a
business line, portfolio, or exposure from the advanced approaches. The
business lines, portfolios, and exposures that the bank proposes to
exclude from the advanced approaches must be, in the aggregate,
immaterial to the bank. The implementation plan must include objective,
measurable milestones (including delivery dates and a date when the
bank's implementation of the advanced approaches will be fully
operational). For core banks, the implementation plan must include an
explicit first floor period start date that is no later than 36 months
after the later of the effective date of the rule or the date the bank
meets at least one of the threshold criteria.\24\ Further, the
implementation plan must describe the resources that the bank has
budgeted and are available to implement the plan.
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\24\ The bank's primary Federal supervisor may extend the bank's
first floor period start date.
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During implementation of the advanced approaches, a bank would work
closely with its primary Federal supervisor to ensure that its risk
measurement and management systems are fully functional and reliable
and are able to generate risk parameter estimates that can be used to
calculate the risk-based capital ratios correctly under the advanced
approaches. The implementation plan, including the gap analysis and
action plan, will provide a basis for ongoing supervisory dialogue and
review during this period. The primary Federal supervisor will assess a
bank's progress relative to its implementation plan. To the extent that
adjustments to target dates are needed, these adjustments would be made
subject to the ongoing supervisory discussion between the bank and its
primary Federal supervisor.
2. Parallel Run and Transitional Floor Periods
Once a bank has adopted its implementation plan, it must complete
[[Page 55843]]
a satisfactory parallel run before it may use the advanced approaches
to calculate its risk-based capital requirements. A satisfactory
parallel run is a period of at least four consecutive calendar quarters
during which the bank complies with all of the qualification
requirements to the satisfaction of its primary Federal supervisor.
During this period, the bank would continue to be subject to the
general risk-based capital rules but would simultaneously calculate its
risk-based capital ratios under the advanced approaches. During the
parallel run period, a bank would report its risk-based capital ratios
under both the general risk-based capital rules and the advanced
approaches to its primary Federal supervisor through the supervisory
process on a quarterly basis. The agencies will share this information
with each other for calibration and other analytical purposes.
A bank's primary Federal supervisor would notify the bank of the
date when it may begin to use the advanced approaches for risk-based
capital purposes. A bank would not be permitted to begin using the
advanced approaches for risk-based capital purposes until its primary
Federal supervisor is satisfied that the bank fully complies with the
qualification requirements, the bank has satisfactorily completed a
parallel run, and the bank has an adequate process to ensure ongoing
compliance with the qualification requirements.
To provide for a smooth transition to the advanced approaches, the
proposed rule would impose temporary limits on the amount by which a
bank's risk-based capital requirements could decline over a period of
at least three years (that is, at least four consecutive calendar
quarters in each of the three transitional floor periods). Based on its
assessment of the bank's ongoing compliance with the qualification
requirements, a bank's primary Federal supervisor would determine when
the bank is ready to move from one transitional floor period to the
next period and, after the full transition has been completed, to move
to stand-alone use of the advanced approaches. Table B sets forth the
proposed transitional floor periods for banks moving to the advanced
approaches:
Table B.--Transitional Floors
------------------------------------------------------------------------
Transitional
Transitional floor period floor
percentage
------------------------------------------------------------------------
First floor period...................................... 95
Second floor period..................................... 90
Third floor period...................................... 85
------------------------------------------------------------------------
During the transitional floor periods, a bank would calculate its
risk-weighted assets under the general risk-based capital rules. Next,
the bank would multiply this risk-weighted assets amount by the
appropriate floor percentage in the table above. This product would be
the bank's ``floor-adjusted'' risk-weighted assets. Third, the bank
would calculate its tier 1 and total risk-based capital ratios using
the definitions of tier 1 and tier 2 capital (and associated deductions
and adjustments) in the general risk-based capital rules for the
numerator values and floor-adjusted risk-weighted assets for the
denominator values. These ratios would be referred to as the ``floor-
adjusted risk-based capital ratios.''
The bank also would calculate its tier 1 and total risk-based
capital ratios using the definitions and rules in this proposed rule.
These ratios would be referred to as the ``advanced approaches risk-
based capital ratios.'' In addition, the bank would calculate a tier 1
leverage ratio using tier 1 capital as defined in this proposed rule
for the numerator of the ratio.
During a bank's transitional floor periods, the bank would report
all five regulatory capital ratios described above--two floor-adjusted
risk-based capital ratios, two advanced approaches risk-based capital
ratios, and one leverage ratio. To determine its applicable capital
category for PCA purposes and for all other regulatory and supervisory
purposes, a bank's risk-based capital ratios during the transitional
floor periods would be set equal to the lower of the respective floor-
adjusted risk-based capital ratio and the advanced approaches risk-
based capital ratio. During the transitional floor periods, a bank's
tier 1 capital and tier 2 capital for all non-risk-based-capital
supervisory and regulatory purposes (for example, lending limits and
Regulation W quantitative limits) would be the bank's tier 1 capital
and tier 2 capital as calculated under the advanced approaches.
Thus, for example, in order to be well capitalized under PCA, a
bank would have to have a floor-adjusted tier 1 risk-based capital
ratio and an advanced approaches tier 1 risk-based capital ratio of 6
percent or greater, a floor-adjusted total risk-based capital ratio and
an advanced approaches total risk-based capital ratio of 10 percent or
greater, and a tier 1 leverage ratio of 5 percent or greater (with tier
1 capital calculated under the advanced approaches). Although the PCA
rules do not apply to BHCs, a BHC would be required to report all five
of these regulatory capital ratios and would have to meet applicable
supervisory and regulatory requirements using the lower of the
respective floor-adjusted risk-based capital ratio and the advanced
approaches risk-based capital ratio.
After a bank completes its transitional floor periods and its
primary Federal supervisor determines the bank may begin using the
advanced approaches with no further transitional floor, the bank would
use its tier 1 and total risk-based capital ratios as calculated under
the advanced approaches and its tier 1 leverage ratio calculated using
the advanced approaches definition of tier 1 capital for PCA and all
other supervisory and regulatory purposes.
The transitional floor calculations described above are linked to
the general risk-based capital rules. As noted above, the agencies
issued the Basel IA ANPR outlining possible modifications to those
rules and are developing an NPR in this regard. The agencies are still
considering the extent and nature of these modifications to the general
risk-based capital rules and the scope of application of these
modifications, including for banks that transition to the advanced
approaches. The agencies expect banks that meet the threshold criteria
in section 1(b)(1) of the proposed rule (that is, core banks) as of the
effective date of the rule, and banks that opt-in pursuant to section
1(b)(2) at the earliest possible date, will use the general risk-based
capital rules in place immediately before the rule becomes effective
both during the parallel run and as a basis for the transitional floor
calculations. Other changes to the general risk-based capital rules
(outside the scope of the changes outlined in the Basel IA ANPR) may be
considered by the agencies, as appropriate. Question 10: The agencies
seek comment on this approach, including the transitional floor
thresholds and transition period, and on how and to what extent future
modifications to the general risk-based capital rules should be
incorporated into the transitional floor calculations for advanced
approaches banks.
Banks' computation of risk-based capital requirements under both
the general risk-based capital rules and the advanced approaches will
help the agencies assess the impact of the advanced approaches on
overall capital requirements, including whether the change in capital
requirements relative to the general risk-based capital rules is
consistent with the agencies' overall capital objectives. Question 11:
The agencies seek comment on what other information should be
considered in deciding whether those overall capital goals have been
achieved.
[[Page 55844]]
The agencies are proposing to make 2008 the first possible year for
a bank to conduct its parallel run and 2009-2011 the first possible
years for the three transitional floor periods. Question 12: The
agencies seek comment on this proposed timetable for implementing the
advanced approaches in the United States.
B. Qualification Requirements
Because the Basel II framework uses banks' estimates of certain key
risk parameters to determine risk-based capital requirements, the
advanced approaches would introduce greater complexity to the
regulatory capital framework and would require banks using the advanced
approaches to possess a high level of sophistication in risk
measurement and risk management systems. As a result, the agencies
propose to require each core or opt-in bank to meet the qualification
requirements described in section 22 of the proposed rule to the
satisfaction of its primary Federal supervisor for a period of at least
four consecutive calendar quarters before using the advanced approaches
to calculate its minimum risk-based capital requirements (subject to
the transitional floors for at least an additional three years). The
qualification requirements are written broadly to accommodate the many
ways a bank may design and implement a robust internal credit and
operational risk measurement and management system and to permit
industry practice to evolve.
Many of the qualification requirements relate to a bank's advanced
IRB systems. A bank's advanced IRB systems must incorporate five
interdependent components in a framework for evaluating credit risk and
measuring regulatory capital:
(i) A risk rating and segmentation system that assigns ratings to
individual wholesale obligors and exposures and assigns individual
retail exposures to segments;
(ii) A quantification process that translates the risk
characteristics of wholesale obligors and exposures and segments of
retail exposures into numerical risk parameters that are used as inputs
to the IRB risk-based capital formulas;
(iii) An ongoing process that validates the accuracy of the rating
assignments, segmentations, and risk parameters;
(iv) A data management and maintenance system that supports the
advanced IRB systems; and
(v) Oversight and control mechanisms that ensure the advanced IRB
systems are functioning effectively and producing accurate results.
1. Process and Systems Requirements
One of the objectives of the proposed framework is to provide
appropriate incentives for banks to develop and use better techniques
for measuring and managing their risks. The proposed rule specifically
requires a bank to have a rigorous process for assessing its overall
capital adequacy in relation to its total risk profile and a
comprehensive strategy for maintaining appropriate capital levels.
Consistent with Pillar 2 of the New Accord, a bank's primary Federal
supervisor will evaluate how well the bank is assessing its capital
needs relative to its risks and, if deficiencies are identified, will
take any necessary action to ensure that appropriate and prudent levels
of capital are maintained.
A bank should address all of its material risks in its overall
capital assessment process. Although not every risk can be measured
precisely, the following risks, at a minimum, should be factored into a
bank's capital assessment process: credit risk, market risk,
operational risk, interest rate risk in the banking book, liquidity
risk, concentration risk, reputational risk, and strategic risk. With
regard to interest rate risk in the banking book, the agencies note
that for some assets--for example, a long-term mortgage loan--interest
rate risk may be as great as, or greater than, the credit risk of the
asset. The agencies will continue to focus attention on exposures where
interest rate risk may be significant and will foster sound interest
rate risk measurement and management practices across banks.
Additionally, because credit risk concentrations can pose substantial
risk to a bank that might be managing individual credits in a
satisfactory manner, a bank also should give proper attention to such
concentrations.
Banks already are required to hold capital sufficient to meet their
risk profiles, and existing rules allow Federal supervisors to require
a bank to increase its capital if its current capital levels are
deficient or some element of its business practices suggests the need
for more capital. Existing supervisory guidance directs banks to
meaningfully tie the identification, monitoring, and evaluation of risk
to the determination of the bank's capital needs. Banks are expected to
implement and continually update the fundamental elements of a sound
internal capital adequacy analysis--identifying and measuring all
material risks, setting capital adequacy goals that relate to risk, and
assessing conformity to the bank's stated objectives. The agencies
expect that all banks operating under the advanced approaches would
address specific assumptions embedded in the advanced approaches (such
as diversification in credit portfolios), and would evaluate these
banks, in part, on their ability to account for deviations from the
underlying assumptions in their own portfolios.
As noted, each core or opt-in bank would apply the advanced
approaches for risk-based capital purposes at the consolidated top-tier
legal entity level (that is, either the top-tier BHC or top-tier DI
that is a core or opt-in bank) and at the level of each DI that is a
subsidiary of such a top-tier legal entity. Thus, each bank that
applies the advanced approaches must have an appropriate infrastructure
with risk measurement and management processes that meet the proposed
rule's qualification requirements and that are appropriate given the
bank's size and level of complexity. Regardless of whether the systems
and models that generate the risk parameters necessary for calculating
a bank's risk-based capital requirements are located at any affiliate
of the bank, each legal entity that applies the advanced approaches
must ensure that the risk parameters (that is, PD, ELGD, LGD, EAD, and
M) and reference data used to determine its risk-based capital
requirements are representative of its own credit and operational risk
exposures.
The proposed rule also requires that the systems and processes that
an advanced approaches bank uses for risk-based capital purposes must
be sufficiently consistent with the bank's internal risk management
processes and management information reporting systems such that data
from the latter processes and systems can be used to verify the
reasonableness of the inputs the bank uses for risk-based capital
purposes.
2. Risk Rating and Segmentation Systems for Wholesale and Retail
Exposures
To implement the IRB framework, a bank must have internal risk
rating and segmentation systems that accurately and reliably
differentiate between degrees of credit risk for wholesale and retail
exposures. As described below, wholesale exposures include most credit
exposures to companies, sovereigns, and governmental entities, as well
as some exposures to individuals. Retail exposures include most credit
exposures to individuals and small businesses that are managed as part
of a segment of exposures with homogeneous risk characteristics.
Together, wholesale and retail
[[Page 55845]]
exposures cover most credit exposures of banks.
To differentiate among degrees of credit risk, a bank must be able
to make meaningful and consistent distinctions among credit exposures
along two dimensions--default risk and loss severity in the event of a
default. In addition, a bank must be able to assign wholesale obligors
to rating grades that approximately reflect likelihood of default and
must be able to assign wholesale exposures to rating grades (or ELGD
and LGD estimates) that approximately reflect the loss severity
expected in the event of default. As discussed below, the proposed rule
requires banks to treat wholesale exposures differently from retail
exposures when differentiating among degrees of credit risk.
Wholesale exposures. For wholesale exposures, a bank must have an
internal risk rating system that indicates the likelihood of default of
each individual obligor and may use an internal risk rating system that
indicates the economic loss rate upon default of each individual
exposure.\25\ A bank would assign an internal risk rating to each
wholesale obligor, which should reflect the obligor's PD--that is, its
long-run average one-year default rate over a reasonable mix of
economic conditions. PD is defined in more detail below.
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\25\ As explained below, a bank that chooses not to use an
internal risk rating system for ELGD and LGD for a wholesale
exposure must directly assign an ELGD and LGD estimate to the
wholesale exposure.
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In determining an obligor rating, a bank should consider key
obligor attributes, including both quantitative and qualitative factors
that could affect the obligor's default risk. From a quantitative
perspective, this could include an assessment of the obligor's historic
and projected financial performance, trends in key financial
performance ratios, financial contingencies, industry risk, and the
obligor's position in the industry. On the qualitative side, this could
include an assessment of the quality of the obligor's financial
reporting, non-financial contingencies (for example, labor problems and
environmental issues), and the quality of the obligor's management
based on an evaluation of management's ability to make realistic
projections, management's track record in meeting projections, and
management's ability to effectively deal with changes in the economy
and the competitive environment.
A bank must assign each legal entity wholesale obligor to a single
rating grade. Accordingly, if a single wholesale exposure of the bank
to an obligor triggers the proposed rule's definition of default, all
of the bank's wholesale exposures to that obligor are in default for
risk-based capital purposes. In addition, a bank may not consider the
value of collateral pledged to support a particular wholesale exposure
(or any other exposure-specific characteristics) when assigning a
rating to the obligor of the exposure, even in the context of
nonrecourse loans and other loans underwritten primarily based on the
operating income or cash flows from real estate collateral. A bank may,
of course, consider all available financial information about the
obligor--including, where applicable, the total operating income or
cash flows from all of the obligor's projects or businesses--when
assigning an obligor rating. Question 13: The agencies seek comment on
this aspect of the proposed rule and on any circumstances under which
it would be appropriate to assign different obligor ratings to
different exposures to the same obligor (for example, income-producing
property lending or exposures involving transfer risk).
A bank's rating system must have at least seven discrete (non-
overlapping) obligor grades for non-defaulted obligors and at least one
obligor grade for defaulted obligors. The agencies believe that because
the risk-based capital requirement of a wholesale exposure is directly
linked to its obligor rating grade, a bank must have at least seven
non-overlapping obligor grades to sufficiently differentiate the
creditworthiness of non-defaulted wholesale obligors.
A bank would capture the estimated loss severity upon default for a
wholesale exposure either by directly assigning an ELGD and LGD
estimate to the exposure or by grouping the exposure with other
wholesale exposures into loss severity rating grades (reflecting the
bank's estimate of the ELGD or LGD of the exposure). The LGD of an
exposure is an estimate of the economic loss rate on the exposure,
taking into account related material costs and recoveries, in the event
of the obligor's default during a period of economic downturn
conditions. LGD is described in more detail below. Whether a bank
chooses to assign ELGD and LGD values directly or, alternatively, to
assign exposures to rating grades and then quantify the ELGD or LGD, as
appropriate, for the rating grades, the key requirement is that the
bank must identify exposure characteristics that influence ELGD and
LGD. Each of the loss severity rating grades would be associated with
an empirically supported ELGD or LGD estimate. Banks employing loss
severity grades must have a sufficiently granular loss severity grading
system to avoid grouping together exposures with widely ranging ELGDs
or LGDs.
Retail exposures. To implement the advanced approach for retail
exposures, a bank must have an internal system that segments its retail
exposures to differentiate accurately and reliably among degrees of
credit risk. The most significant difference between the proposed
rule's treatment of wholesale and retail exposures is that the risk
parameters for retail exposures are not assigned at the individual
exposure level. Banks typically manage retail exposures on a segment
basis, where each segment contains exposures with similar risk
characteristics. Therefore, a key characteristic of the proposed rule's
retail framework is that the risk parameters for retail exposures would
be assigned to segments of exposures rather than to individual
exposures. Under the retail framework, a bank would group its retail
exposures into segments with homogeneous risk characteristics and then
estimate PD, ELGD, and LGD for each segment.
A bank must first group its retail exposures into three separate
subcategories: (i) Residential mortgage exposures; (ii) QREs; and (iii)
other retail exposures. The bank would then classify the retail
exposures in each subcategory into segments to produce a meaningful
differentiation of risk. The proposed rule requires banks to segment
separately (i) defaulted retail exposures from non-defaulted retail
exposures and (ii) retail eligible margin loans for which the bank
adjusts EAD rather than ELGD and LGD to reflect the risk mitigating
effects of financial collateral from other retail eligible margin
loans. Otherwise, the agencies are not proposing to require that banks
consider any particular risk drivers or employ any minimum number of
segments in any of the three retail subcategories.
In determining how to segment retail exposures within each
subcategory for the purpose of assigning risk parameters, a bank should
use a segmentation approach that is consistent with its approach for
internal risk assessment purposes and that classifies exposures
according to predominant risk characteristics or drivers. Examples of
risk drivers could include loan-to-value (LTV) ratios, credit scores,
loan terms and structure (for example, interest only or payment option
adjustable rate mortgages), origination channel, geographical location
of the borrower, and collateral type. A bank must be able to
demonstrate to its primary Federal
[[Page 55846]]
supervisor that its system assigns accurate and reliable PD, ELGD, and
LGD estimates for each retail segment on a consistent basis.
Definition of default. In the ANPR, the agencies proposed to define
default for a wholesale exposure as either or both of the following
events: (i) The bank determines that the borrower is unlikely to pay
its obligations to the bank in full, without recourse to actions by the
bank such as the realization of collateral; or (ii) the borrower is
more than 90 days past due on principal or interest on any material
obligation to the bank.
A number of commenters encouraged the agencies to use a definition
of default that conforms more closely to that used by bank risk
managers. Many of these commenters recommended that the agencies define
default as the entry into non-accrual status for wholesale exposures
and the number of days past due for retail exposures, or as the entry
into charge-off status for wholesale and retail exposures. The agencies
have amended the ANPR definitions of default to respond to these
concerns and recognize that the definition of default in this proposed
rule is different from the definitions that are being implemented in
other jurisdictions.
Under the proposed rule's definition of default, a bank's wholesale
obligor would be in default if, for any credit exposure of the bank to
the obligor, the bank has (i) placed the exposure on non-accrual status
consistent with the Call Report Instructions or the Thrift Financial
Report and the Thrift Financial Report Instruction Manual; (ii) taken a
full or partial charge-off or write-down on the exposure due to the
distressed financial condition of the obligor; or (iii) incurred a
credit-related loss of 5 percent or more of the exposure's initial
carrying value in connection with the sale of the exposure or the
transfer of the exposure to the held-for-sale, available-for-sale,
trading account, or other reporting category. Under the proposed
definition, a wholesale exposure to an obligor remains in default until
the bank has reasonable assurance of repayment and performance for all
contractual principal and interest payments on all exposures of the
bank to the obligor (other than exposures that have been fully written-
down or charged-off). The agencies would expect a bank to employ
standards for determining whether it has a reasonable assurance of
repayment and performance that are similar to those for determining
whether to restore a loan from non-accrual to accrual status.
When a bank sells a set of wholesale exposures, the bank must
examine the sale prices of the individual exposures contained in the
set and evaluate whether a credit loss of 5 percent or more of the
exposure's initial carrying value has occurred on any given exposure.
Write-downs of securities that are not credit-related (for example, a
write-down that is due to a change in market interest rates) would not
be a default event.
Question 14: The agencies seek comment on this proposed definition
of default and on how well it captures substantially all of the
circumstances under which a bank could experience a material credit-
related economic loss on a wholesale exposure. In particular, the
agencies seek comment on the appropriateness of the 5 percent credit
loss threshold for exposures sold or transferred between reporting
categories. The agencies also seek commenters' views on specific issues
raised by applying different definitions of default in multiple
national jurisdictions and on ways to minimize potential regulatory
burden, including use of the definition of default in the New Accord,
keeping in mind that national bank supervisory authorities must adopt
default definitions that are appropriate in light of national banking
practices and conditions.
In response to comments on the ANPR, the agencies propose to define
default for retail exposures according to the timeframes for loss
classification that banks generally use for internal purposes and that
are embodied in the FFIEC's Uniform Retail Credit Classification and
Account Management Policy.\26\ Specifically, revolving retail exposures
and residential mortgages would be in default at 180 days past due;
other retail exposures would be in default at 120 days past due. In
addition, a retail exposure would be in default if the bank has taken a
full or partial charge-off or write-down of principal on the exposure
for credit-related reasons. Such an exposure would remain in default
until the bank has reasonable assurance of repayment and performance
for all contractual principal and interest payments on the exposure.
---------------------------------------------------------------------------
\26\ FFIEC, ``Uniform Retail Credit Classification and Account
Management Policy,'' 65 FR 36903 (June 12, 2000).
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The proposed definition of default for retail exposures differs
from the proposed definition for the wholesale portfolio in several
important respects. First, the proposed retail default definition
applies on an exposure-by-exposure basis (rather than, as is the case
for wholesale exposures, on an obligor-by-obligor basis). In other
words, default on one retail exposure would not require a bank to treat
all other obligations of the same obligor to the bank as defaulted.
This difference reflects the fact that banks generally manage retail
credit risk based on segments of similar exposures rather than through
the assignment of ratings to particular obligors. In addition, it is
quite common for retail borrowers that default on some of their
obligations to continue payment on others.
Second, the retail definition of default, unlike the wholesale
definition of default, does not include exposures placed on non-accrual
status. The agencies recognize that retail non-accrual practices vary
considerably among banks. Accordingly, the agencies have determined
that removing non-accrual from the retail definition of default would
promote greater consistency among banks in the treatment of retail
exposures.
In addition, the retail definition of default, unlike the wholesale
definition of default, does not explicitly state that an exposure is in
default if a bank incurs credit-related losses of 5 percent or more in
connection with the sale of the exposure. Because of the large number
of diverse retail exposures that banks usually sell in a single
transaction, banks typically do not allocate the sales price of a pool
of retail exposures in such a way as to enable the bank to calculate
the premium or discount on individual retail exposures. Although the
proposed rule's definition of retail default does not explicitly
include credit-related losses in connection with loan sales, the
agencies would expect banks to assess carefully the impact of retail
exposure sales in quantifying the risk parameters calculated by the
bank for its retained retail exposures.
Rating philosophy. A bank must explain to its primary Federal
supervisor its rating philosophy--that is, how the bank's wholesale
obligor rating assignments are affected by the bank's choice of the
range of economic, business, and industry conditions that are
considered in the obligor rating process. The philosophical basis of a
bank's ratings system is important because, when combined with the
credit quality of individual obligors, it will determine the frequency
of obligor rating changes in a changing economic environment. Rating
systems that rate obligors based on their ability to perform over a
wide range of economic, business, and industry conditions, sometimes
described as ``through-the-cycle'' systems, would tend to have ratings
that migrate more slowly as conditions change. Banks that rate
[[Page 55847]]
obligors based on a more narrow range of likely expected conditions
(primarily on recent conditions), sometimes called ``point-in-time''
systems, would tend to have ratings that migrate more frequently. Many
banks will rate obligors using an approach that considers a combination
of the current conditions and a wider range of other likely conditions.
In any case, the bank would need to specify the rating philosophy used
and establish a policy for the migration of obligors from one rating
grade to another in response to economic cycles. A bank should
understand the effects of ratings migration on its risk-based capital
requirements and ensure that sufficient capital is maintained during
all phases of the economic cycle.
Rating and segmentation reviews and updates. A bank must have a
policy that ensures that each wholesale obligor rating and (if
applicable) wholesale exposure loss severity rating reflects current
information. A bank's internal risk rating system for wholesale
exposures must provide for the review and update (as appropriate) of
each obligor rating and (if applicable) loss severity rating whenever
the bank receives new material information, but no less frequently than
annually. A bank's retail exposure segmentation system must provide for
the review and update (as appropriate) of assignments of retail
exposures to segments whenever the bank receives new material
information, but no less frequently than quarterly.
3. Quantification of Risk Parameters for Wholesale and Retail Exposures
A bank must have a comprehensive risk parameter quantification
process that produces accurate, timely, and reliable estimates of the
risk parameters--PD, ELGD, LGD, EAD, and (for wholesale exposures) M--
for its wholesale obligors and exposures and retail exposures.
Statistical methods and models used to develop risk parameter
estimates, as well as any adjustments to the estimates or empirical
default data, should be transparent, well supported, and documented.
The following sections of the preamble discuss the proposed rule's
definitions of the risk parameters for wholesale and retail exposures.
Probability of default (PD). As noted above, under the proposed
rule, a bank must assign each of its wholesale obligors to an internal
rating grade and then must associate a PD with each rating grade. PD
for a wholesale exposure to a non-defaulted obligor would be the bank's
empirically based best estimate of the long-run average of one-year
default rates for the rating grade assigned by the bank to the obligor,
capturing the average default experience for obligors in the rating
grade over a mix of economic conditions (including economic downturn
conditions) sufficient to provide a reasonable estimate of the average
one-year default rate over the economic cycle for the rating grade.
This estimate of the long-run average PD is converted into an estimate
of PD under economic downturn conditions as part of the IRB risk-based
capital formulas.
In addition, under the proposed rule, a bank must assign a PD to
each segment of retail exposures. The proposed rule provides two
different definitions of the PD of a segment of non-defaulted retail
exposures based on the materiality of seasoning effects for the segment
or for the segment's retail exposure subcategory. Some types of retail
exposures display a distinct seasoning pattern--that is, the exposures
have relatively low default rates in their first year, rising default
rates in the next few years, and declining default rates for the
remainder of their terms. A bank must use a separate definition of PD
that addresses seasoning effects for a segment of non-defaulted retail
exposures unless the bank has determined that seasoning effects are not
material for the segment or for the segment's entire retail exposure
subcategory.
The proposed rule provides a definition of PD for segments of non-
defaulted retail exposures where seasoning is not a material
consideration that tracks closely the wholesale PD definition.
Specifically, PD for a segment of non-defaulted retail exposures for
which seasoning effects are not material, or for a segment of non-
defaulted retail exposures in a retail exposure subcategory for which
seasoning effects are not material, would be the bank's empirically
based best estimate of the long-run average of one-year default rates
for the exposures in the segment, capturing the average default
experience for exposures in the segment over a mix of economic
conditions (including economic downturn conditions) sufficient to
provide a reasonable estimate of the average one-year default rate over
the economic cycle for the segment. Banks that use this PD formulation
for a segment of retail exposures should be able to demonstrate to
their primary Federal supervisor, using empirical data, why seasoning
effects are not material for the segment or the retail exposure
subcategory in which the segment resides.
Because of the one-year IRB horizon, the agencies are proposing a
different PD definition for retail segments with material seasoning
effects. Under the proposed rule, PD for a segment of non-defaulted
retail exposures for which seasoning effects are material would be the
bank's empirically based best estimate of the annualized cumulative
default rate over the expected remaining life of exposures in the
segment, capturing the average default experience for exposures in the
segment over a mix of economic conditions (including economic downturn
conditions) to provide a reasonable estimate of the average performance
over the economic cycle for the segment. A bank's PD estimates for
these retail segments with material seasoning effects also should
reflect potential changes in the expected remaining life of exposures
in the segment over the economic cycle.
For wholesale exposures to defaulted obligors and for segments of
defaulted retail exposures, PD would be 100 percent.
Loss given default (LGD) and expected loss given default (ELGD).
Under the proposed rule, a bank must directly estimate an ELGD and LGD
risk parameter for each wholesale exposure or must assign each
wholesale exposure to an expected loss severity grade and a downturn
loss severity grade, estimate an ELGD risk parameter for each expected
loss severity grade, and estimate an LGD risk parameter for each loss
severity grade. In addition, a bank must estimate an ELGD and LGD risk
parameter for each segment of retail exposures. The same ELGD and LGD
may be appropriate for more than one retail segment.
LGD is an estimate of the economic loss that would be incurred on
an exposure, relative to the exposure's EAD, if the exposure were to
default within a one-year horizon during economic downturn conditions.
The economic loss amount must capture all material credit-related
losses on the exposure (including accrued but unpaid interest or fees,
losses on the sale of repossessed collateral, direct workout costs, and
an appropriate allocation of indirect workout costs). Where positive or
negative cash flows on a wholesale exposure to a defaulted obligor or
on a defaulted retail exposure (including proceeds from the sale of
collateral, workout costs, and draw-downs of unused credit lines) occur
after the date of default, the economic loss amount must reflect the
net present value of cash flows as of the default date using a discount
rate appropriate to the risk of the exposure.
[[Page 55848]]
The LGD of some exposures may be substantially higher during
economic downturn conditions than during other periods, while for other
types of exposures it may not. Accordingly, the proposed rule requires
banks to use an LGD estimate that reflects economic downturn conditions
for purposes of calculating the risk-based capital requirements for
wholesale exposures and retail segments; however, the LGD of an
exposure may never be less than the exposure's ELGD. More specifically,
banks must produce for each wholesale exposure (or downturn loss
severity rating grade) and retail segment an estimate of the economic
loss per dollar of EAD that the bank would expect to incur if default
were to occur within a one-year horizon during economic downturn
conditions. The estimate of LGD can be thought of as the ELGD plus an
increase if appropriate to reflect the impact of economic downturn
conditions.
For the purpose of defining economic downturn conditions, the
proposed rule identifies two wholesale exposure subcategories--high-
volatility commercial real estate (HVCRE) wholesale exposures and non-
HVCRE wholesale exposures (that is, all wholesale exposures that are
not HVCRE exposures)--and three retail exposure subcategories--
residential mortgage exposures, QREs, and other retail exposures. The
proposed rule defines economic downturn conditions with respect to an
exposure as those conditions in which the aggregate default rates for
the exposure's entire wholesale or retail subcategory held by the bank
(or subdivision of such subcategory selected by the bank) in the
exposure's national jurisdiction (or subdivision of such jurisdiction
selected by the bank) are significantly higher than average.
Under this approach, a bank with a geographical or industry sector
concentration in a subcategory of exposures may find that information
relating to a downturn in that geographical region or industry sector
may be more relevant for the bank than a general downturn affecting
many regions or industries. At this time, however, the proposed rule
does not require a bank with a geographical, industry sector, or other
concentration to subdivide exposure subcategories or national
jurisdictions to reflect such concentrations; rather, the proposed rule
allows banks to subdivide exposure subcategories or national
jurisdictions as they deem appropriate given the exposures held by the
bank. The agencies understand that downturns in particular geographical
subdivisions of national jurisdictions or in particular industrial
sectors may result in significantly increased loss rates in material
subdivisions of a bank's exposures in an exposure subcategory. Question
15: In light of the possibility of significantly increased loss rates
at the subdivision level due to downturn conditions in the subdivision,
the agencies seek comment on whether to require banks to determine
economic downturn conditions at a more granular level than an entire
wholesale or retail exposure subcategory in a national jurisdiction.
The proposed rule provides banks two methods of generating LGD
estimates for wholesale and retail exposures. First, a bank may use its
own estimates of LGD for a subcategory of exposures if the bank has
prior written approval from its primary Federal supervisor to use
internal estimates for that subcategory of exposures. In approving a
bank's use of internal estimates of LGD, a bank's primary Federal
supervisor will consider whether the bank's internal estimates of LGD
are reliable and sufficiently reflective of economic downturn
conditions. The supervisor will also consider whether the bank has
rigorous and well-documented policies and procedures for identifying
economic downturn conditions for the exposure subcategory, identifying
material adverse correlations between the relevant drivers of default
rates and loss rates given default, and incorporating identified
correlations into internal LGD estimates. If a bank has supervisory
approval to use its own estimates of LGD for an exposure subcategory,
it must use its own estimates of LGD for all exposures within that
subcategory.
As noted above, the LGD of an exposure or segment may never be less
than the ELGD of that exposure or segment. The proposed rule defines
the ELGD of a wholesale exposure as the bank's empirically-based best
estimate of the default-weighted average economic loss per dollar of
EAD the bank expects to incur in the event that the obligor of the
exposure (or a typical obligor in the loss severity grade assigned by
the bank to the exposure) defaults within a one-year horizon.\27\ For a
segment of retail exposures, ELGD is the bank's empirically-based best
estimate of the default-weighted average economic loss per dollar of
EAD the bank expects to incur on exposures in the segment that default
within a one-year horizon. ELGD estimates must incorporate a mix of
economic conditions (including economic downturn conditions). For
example, given appropriate data, the ELGD could be estimated by
calculating the default-weighted average economic loss per dollar of
EAD given default for exposures in a particular loss severity grade or
segment observed over a complete credit cycle.
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\27\ Under the proposal, ELGD is not the statistical expected
value of LGD.
---------------------------------------------------------------------------
As an alternative to internal estimates of LGD, the proposed rule
provides a supervisory mapping function for converting ELGD into LGD
for risk-based capital purposes. Although the agencies encourage banks
to develop internal LGD estimates, the agencies are aware that it may
be difficult at this time and in the near future for banks to produce
internal estimates of LGD that are sufficient for risk-based capital
purposes because LGD data for important portfolios may be sparse, and
there is very limited industry experience with incorporating downturn
conditions into LGD estimates. Accordingly, under the proposed rule, a
bank that does not qualify for use of its own estimates of LGD for a
subcategory of exposures must instead compute LGD by applying a
supervisory mapping function to its internal estimates of ELGD for such
exposures. The bank would adjust its ELGDs upward to LGDs using the
linear supervisory mapping function: LGD = 0.08 + 0.92 x ELGD. Under
this mapping function, for example, an ELGD of 0 percent is converted
to an LGD of 8 percent, an ELGD of 20 percent is converted to an LGD of
26.4 percent, and an ELGD of 50 percent is converted to an LGD of 54
percent. A bank would not have to apply the supervisory mapping
function to repo-style transactions, eligible margin loans, and OTC
derivative contracts (defined below in section V.C. of the preamble).
For these exposures, the agencies believe that the difference between a
bank's estimate of LGD and its estimate of ELGD is likely to be small.
Instead a bank would set LGD equal to ELGD for these exposures.
As noted, the proposed rule would permit a bank to use the
supervisory mapping function to translate ELGDs to LGDs and would only
permit a bank to use its own estimates of LGD for an exposure
subcategory if the bank has received prior written approval from its
primary Federal supervisor. The agencies also are considering whether
to require every bank, as a condition to qualifying for use of the
advanced approaches, to be able to produce credible and reliable
internal estimates of LGD for all its wholesale and retail exposures.
Under this stricter approach, a bank that is unable to demonstrate to
[[Page 55849]]
its primary Federal supervisor that it could produce credible and
reliable internal estimates of LGD would not be permitted to use the
advanced approaches.
Question 16: The agencies seek comment on and supporting empirical
analysis of (i) the proposed rule's definitions of LGD and ELGD; (ii)
the proposed rule's overall approach to LGD estimation; (iii) the
appropriateness of requiring a bank to produce credible and reliable
internal estimates of LGD for all its wholesale and retail exposures as
a precondition for using the advanced approaches; (iv) the
appropriateness of requiring all banks to use a supervisory mapping
function, rather than internal estimates, for estimating LGDs, due to
limited data availability and lack of industry experience with
incorporating economic downturn conditions in LGD estimates; (v) the
appropriateness of the proposed supervisory mapping function for
translating ELGD into LGD for all portfolios of exposures and possible
alternative supervisory mapping functions; (vi) exposures for which no
mapping function would be appropriate; and (vii) exposures for which a
more lenient (that is, producing a lower LGD for a given ELGD) or more
strict (that is, producing a higher LGD for a given ELGD) mapping
function may be appropriate (for example, residential mortgage
exposures and HVCRE exposures).
The agencies are concerned that some approaches to ELGD or LGD
quantification could produce estimates that are pro-cyclical,
particularly if these estimates are based on economic indicators, such
as frequently updated loan-to-value (LTV) ratios, that are highly
sensitive to current economic conditions. Question 17: The agencies
seek comment on the extent to which ELGD or LGD estimates under the
proposed rule would be pro-cyclical, particularly for longer-term
secured exposures. The agencies also seek comment on alternative
approaches to measuring ELGDs or LGDs that would address concerns
regarding potential pro-cyclicality without imposing undue burden on
banks.
This proposed rule incorporates comments on the ANPR suggesting a
need to better accommodate certain credit products, most prominently
asset-based lending programs, whose structures typically result in a
bank recovering substantial amounts of the exposure prior to the
default date--for example, through paydowns of outstanding principal.
The agencies believe that actions taken prior to default to mitigate
losses are an important component of a bank's overall credit risk
management, and that such actions should be reflected in ELGD and LGD
when banks can quantify their effectiveness in a reliable manner. In
the proposed rule, this is achieved by measuring ELGD and LGD relative
to the exposure's EAD (defined in the next section) as opposed to the
amount actually owed at default.\28\
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\28\ To illustrate, suppose that for a particular asset-based
lending exposure, the EAD equaled $100 and that for every $1 owed by
the obligor at the time of default, the bank's recovery would be
$0.40. Furthermore, suppose that in the event of default, within a
one-year horizon, pre-default paydowns of $20 would reduce the
exposure amount to $80 at the time of default. In this case, the
bank's economic loss rate measured relative to the amount owed at
default (60%) would exceed the economic loss rate measured relative
to EAD (48% = 60% x ($100 - $20)/$100), because the former does not
reflect fully the impact of the pre-default paydowns.
---------------------------------------------------------------------------
In practice, the agencies would expect methods for estimating ELGD
and LGD, and the way those methods reflect changes in exposure during
the period prior to default, to be consistent with other aspects of the
proposed rule. For example, a default horizon that is longer than one
year could result in lower estimates of economic loss due to greater
contractual amortization prior to default, or a greater likelihood that
covenants would enable a bank to accelerate paydowns of principal as
the condition of an obligor deteriorates, but such long horizons could
be inconsistent with the one-year default horizon incorporated in other
aspects of this proposed rule, such as the quantification of PD.
The agencies intend to limit recognition of the impact on ELGD and
LGD of pre-default paydowns to certain types of exposures where the
pattern is common, measurable, and especially significant, as with
various types of asset-based lending. In addition, not all paydowns
during the period prior to default warrant recognition as part of the
recovery process. For example, a pre-default reduction in the
outstanding amount on one exposure may simply reflect a refinancing by
the obligor with the bank, with no reduction in the bank's total
exposure to the obligor. Question 18: The agencies seek comment on the
feasibility of recognizing such pre-default changes in exposure in a
way that is consistent with the safety and soundness objectives of this
proposed rule. The agencies also seek comment on appropriate
restrictions to place on any such recognition to ensure that the
results are not counter to the objectives of this proposal to ensure
adequate capital within a more risk-sensitive capital framework. In
addition, the agencies seek comment on whether, for wholesale
exposures, allowing ELGD and LGD to reflect anticipated future
contractual paydowns prior to default may be inconsistent with the
proposed rule's imposition of a one-year floor on M (for certain types
of exposures) or may lead to some double-counting of the risk-
mitigating benefits of shorter maturities for exposures not subject to
this floor.
Exposure at default (EAD). Except as noted below, EAD for the on-
balance- sheet component of a wholesale or retail exposure means (i)
the bank's carrying value for the exposure (including net accrued but
unpaid interest and fees) \29\ less any allocated transfer risk reserve
for the exposure, if the exposure is held-to-maturity or for trading;
or (ii) the bank's carrying value for the exposure (including net
accrued but unpaid interest and fees) less any allocated transfer risk
reserve for the exposure and any unrealized gains on the exposure, plus
any unrealized losses on the exposure, if the exposure is available for
sale. For the off-balance-sheet component of a wholesale or retail
exposure (other than an OTC derivative contract, repo-style
transaction, or eligible margin loan) in the form of a loan commitment
or line of credit, EAD means the bank's best estimate of net additions
to the outstanding amount owed the bank, including estimated future
additional draws of principal and accrued but unpaid interest and fees,
that are likely to occur over the remaining life of the exposure
assuming the exposure were to go into default. This estimate of net
additions must reflect what would be expected during a period of
economic downturn conditions. For the off-balance-sheet component of a
wholesale or retail exposure other than an OTC derivative contract,
repo-style transaction, eligible margin loan, loan commitment, or line
of credit issued by a bank, EAD means the notional amount of the
exposure.
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\29\ ``Net accrued but unpaid interest and fees'' are accrued
but unpaid interest and fees net of any amount expensed by the bank
as uncollectable.
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For a segment of retail exposures, EAD is the sum of the EADs for
each individual exposure in the segment. For wholesale or retail
exposures in which only the drawn balance has been securitized, the
bank must reflect its share of the exposures' undrawn balances in EAD.
The undrawn balances of exposures for which the drawn balances have
been securitized must be allocated between the seller's and investors'
interests on a pro rata basis, based on the proportions of the seller's
and investors' shares of the securitized drawn balances. For example,
if the
[[Page 55850]]
EAD of a group of securitized exposures' undrawn balances is $100, and
the bank's share (seller's interest) in the securitized exposures is 25
percent, the bank must reflect $25 in EAD for the undrawn balances.
The proposed rule contains a special treatment of EAD for OTC
derivative contracts, repo-style transactions, and eligible margin
loans, which is in section 32 of the proposed rule and discussed in
more detail in section V.C. of the preamble.
General quantification principles. The proposed rule requires data
used by a bank to estimate risk parameters to be relevant to the bank's
actual wholesale and retail exposures and of sufficient quality to
support the determination of risk-based capital requirements for the
exposures. For wholesale exposures, estimation of the risk parameters
must be based on a minimum of 5 years of default data to estimate PD, 7
years of loss severity data to estimate ELGD and LGD, and 7 years of
exposure amount data to estimate EAD. For segments of retail exposures,
estimation of risk parameters must be based on a minimum of 5 years of
default data to estimate PD, 5 years of loss severity data to estimate
ELGD and LGD, and 5 years of exposure amount data to estimate EAD.
Default, loss severity, and exposure amount data must include periods
of economic downturn conditions or the bank must adjust its estimates
of risk parameters to compensate for the lack of data from such
periods. Banks must base their estimates of PD, ELGD, LGD, and EAD on
the proposed rule's definition of default, and must review at least
annually and update (as appropriate) their risk parameters and risk
parameter quantification process.
In all cases, banks would be expected to use the best available
data for quantifying the risk parameters. A bank could meet the minimum
data requirement by using internal data, external data, or pooled data
combining internal data with external data. Internal data refers to any
data on exposures held in a bank's existing or historical portfolios,
including data elements or information provided by third parties.
External data refers to information on exposures held outside of the
bank's portfolio or aggregate information across an industry.
For example, for new lines of business where a bank lacks
sufficient internal data, it must use external data to supplement its
internal data. The agencies recognize that the minimum sample period
for reference data provided in the proposed rule may not provide the
best available results. A longer sample period usually captures varying
economic conditions better than a shorter sample period; in addition, a
longer sample period will include more default observations for ELGD,
LGD, and EAD estimation. Banks should consider using a longer-than-
minimum sample period when possible. However, the potential increase in
precision afforded by a larger sample should be weighed against the
potential for diminished comparability of older data to the existing
portfolio; striking the correct balance is an important aspect of
quantitative modeling.
Both internal and external reference data should not differ
systematically from a bank's existing portfolio in ways that seem
likely to be related to default risk, loss severity, or exposure at
default. Otherwise, the derived PD, ELGD, LGD, or EAD estimates may not
be applicable to the bank's existing portfolio. Accordingly, the bank
must conduct a comprehensive review and analysis of reference data at
least annually to determine the relevance of reference data to the
bank's exposures, the quality of reference data to support PD, ELGD,
LGD, and EAD estimates, and the consistency of reference data to the
definition of default contained in the proposed rule. Furthermore, a
bank must have adequate data to estimate risk parameters for all its
wholesale and retail exposures as if they were held to maturity, even
if some loans are likely to be sold or securitized before their long-
term credit performance can be observed.
As noted above, periods of economic downturn conditions must be
included in the data sample (or adjustments to risk parameters must be
made). If the reference data include data from beyond the minimum
number of years (to capture a period of economic downturn conditions or
for other valid reasons), the reference data need not cover all of the
intervening years. However, a bank should justify the exclusion of
available data and, in particular, any temporal discontinuities in data
used. Including periods of economic downturn conditions increases the
size and potentially the breadth of the reference data set. According
to some empirical studies, the average loss rate is higher during
periods of economic downturn conditions, such that exclusion of such
periods would bias ELGD, LGD, or EAD estimates downward and
unjustifiably lower risk-based capital requirements.
Risk parameter estimates should take into account the robustness of
the quantification process. The assumptions and adjustments embedded in
the quantification process should reflect the degree of uncertainty or
potential error inherent in the process. In practice, a reasonable
estimation approach likely would result in a range of defensible risk
parameter estimates. The choices of the particular assumptions and
adjustments that determine the final estimate, within the defensible
range, should reflect the uncertainty in the quantification process.
That is, more uncertainty in the process should be reflected in the
assignment of final risk parameter estimates that result in higher
risk-based capital requirements relative to a quantification process
with less uncertainty. The degree of conservatism applied to adjust for
uncertainty should be related to factors such as the relevance of the
reference data to a bank's existing exposures, the robustness of the
models, the precision of the statistical estimates, and the amount of
judgment used throughout the process. Margins of conservatism need not
be added at each step; indeed, that could produce an excessively
conservative result. Instead, the overall margin of conservatism should
adequately account for all uncertainties and weaknesses in the
quantification process. Improvements in the quantification process
(including use of more complete data and better estimation techniques)
may reduce the appropriate degree of conservatism over time.
Judgment will inevitably play a role in the quantification process
and may materially affect the estimates of risk parameters. Judgmental
adjustments to estimates are often necessary because of some
limitations on available reference data or because of inherent
differences between the reference data and the bank's existing
exposures. The bank must ensure that adjustments are not biased toward
optimistically low risk parameter estimates. This standard does not
prohibit individual adjustments that result in lower estimates of risk
parameters, as both upward and downward adjustments are expected.
Individual adjustments are less important than broad patterns;
consistent signs of judgmental decisions that lower risk parameter
estimates materially may be evidence of systematic bias, which would
not be permitted.
In estimating relevant risk parameters, banks should not rely on
the possibility of U.S. government financial assistance, except for the
financial assistance that the government has legally committed to
provide.
4. Optional Approaches That Require Prior Supervisory Approval
A bank that intends to apply the internal models methodology to
[[Page 55851]]
counterparty credit risk, the double default treatment for credit risk
mitigation, the internal assessment approach (IAA) for securitization
exposures to ABCP programs, or the internal models approach (IMA) to
equity exposures must receive prior written approval from its primary
Federal supervisor. The criteria on which approval would be based are
described in the respective sections below.
5. Operational Risk
A bank must have operational risk management processes, data and
assessment systems, and quantification systems that meet the
qualification requirements in section 22(h) of the proposed rule. A
bank must have an operational risk management function independent from
business line management. The operational risk management function is
responsible for the design, implementation, and oversight of the bank's
operational risk data and assessment systems, operational risk
quantification systems, and related processes. The roles and
responsibilities of the operational risk management function may vary
between banks, but must be clearly documented. The operational risk
management function should have organizational stature commensurate
with the bank's operational risk profile. At a minimum, the bank's
operational risk management function should ensure the development of
policies and procedures for the explicit management of operational risk
as a distinct risk to the bank's safety and soundness.
A bank also must establish and document a process to identify,
measure, monitor, and control operational risk in bank products,
activities, processes, and systems. This process should provide for the
consistent and comprehensive collection of the data needed to estimate
the bank's exposure to operational risk. The process must also ensure
reporting of operational risk exposures, operational loss events, and
other relevant operational risk information to business unit
management, senior management, and to the board of directors (or a
designated committee of the board). The proposed rule defines
operational loss events as events that result in loss and are
associated with internal fraud; external fraud; employment practices
and workplace safety; clients, products, and business practices; damage
to physical assets; business disruption and system failures; or
execution, delivery, and process management. A bank's operational risk
management processes should reflect the scope and complexity of its
business lines, as well as its corporate organizational structure. Each
bank's operational risk profile is unique and requires a tailored risk
management approach appropriate for the scale and materiality of the
operational risks present in the bank.
Operational risk data and assessment system. A bank must have an
operational risk data and assessment system that incorporates on an
ongoing basis the following four elements: internal operational loss
event data, external operational loss event data, results of scenario
analysis, and assessments of the bank's business environment and
internal controls. These four operational risk elements should aid the
bank in identifying the level and trend of operational risk,
determining the effectiveness of operational risk management and
control efforts, highlighting opportunities to better mitigate
operational risk, and assessing operational risk on a forward-looking
basis. A bank's operational risk data and assessment system must be
structured in a manner consistent with the bank's current business
activities, risk profile, technological processes, and risk management
processes.
The proposed rule defines operational loss as a loss (excluding
insurance or tax effects) resulting from an operational loss event.
Operational losses include all expenses associated with an operational
loss event except for opportunity costs, forgone revenue, and costs
related to risk management and control enhancements implemented to
prevent future operational losses. The definition of operational loss
is an important issue, as it is a critical building block in a bank's
calculation of its operational risk capital requirement under the AMA.
More specifically, under the proposed rule, the bank's estimate of
operational risk exposure--the basis for determining a bank's risk-
weighted asset amount for operational risk--is an estimate of aggregate
operational losses generated by the bank's AMA process.
The agencies are considering whether to define operational loss
based solely on the effect of an operational loss event on a bank's
regulatory capital or to use a definition of operational loss that
incorporates, to a greater extent, economic capital concepts. In either
case, operational losses would continue to be determined exclusive of
insurance and tax effects.
With respect to most operational loss events, the agencies believe
that the operational loss amount incorporated into a bank's AMA process
would be substantially the same whether viewed from the perspective of
its effect on the bank's regulatory capital or an alternative approach
that more directly incorporates economic capital concepts. In the case
of operational loss events associated with premises and other fixed
assets, however, potential loss amounts used in a bank's estimate of
its operational risk exposure could be considerably different under the
two approaches. The agencies recognize that, for purposes of economic
capital analysis, banks often use replacement cost or market value, and
not carrying value, to determine the amount of an operational loss with
respect to fixed assets. The use of carrying value would be consistent
with a definition of operational loss that covers a loss event's effect
on a bank's regulatory capital, but may not reflect the full economic
impact of a loss event in the case of assets that have a carrying value
that is different from their market value.
Further, the agencies recognize that there is a potential to
double-count all or a portion of the risk-based capital requirement
associated with fixed assets. Under section 31(e)(3) of the proposed
rule, which addresses calculation of risk-weighted asset amounts for
assets that are not included in an exposure category, the risk-weighted
asset amount for a bank's premises will equal the carrying value of the
premises on the financial statements of the bank, determined in
accordance with generally accepted accounting principles (GAAP). A
bank's operational risk exposure estimate addressing bank premises
generally will be different than the risk-based capital requirement
generated under section 31(e)(3) of the proposed rule and, at least in
part, will address the same risk exposure.
Question 19: The agencies solicit comment on all aspects of the
proposed treatment of operational loss and, in particular, on (i) the
appropriateness of the proposed definition of operational loss; (ii)
whether the agencies should define operational loss in terms of the
effect an operational loss event has on the bank's regulatory capital
or should consider a broader definition based on economic capital
concepts; and (iii) how the agencies should address the potential
double-counting issue for premises and other fixed assets.
A bank must have a systematic process for capturing and using
internal operational loss event data in its operational risk data and
assessment systems. Consistent with the ANPR, the proposed rule defines
internal operational loss event data for a bank as gross operational
loss amounts, dates,
[[Page 55852]]
recoveries, and relevant causal information for operational loss events
occurring at the bank. A bank's operational risk data and assessment
system must include a minimum historical observation period of five
years of internal operational losses. With approval of its primary
Federal supervisor, however, a bank may use a shorter historical
observation period to address transitional situations such as
integrating a new business line. A bank may refrain from collecting
internal operational loss event data for individual operational losses
below established dollar threshold amounts if the bank can demonstrate
to the satisfaction of its primary Federal supervisor that the
thresholds are reasonable, do not exclude important internal
operational loss event data, and permit the bank to capture
substantially all the dollar value of the bank's operational losses.
A bank also must establish a systematic process for determining its
methodologies for incorporating external operational loss event data
into its operational risk data and assessment systems. The proposed
rule defines external operational loss event data for a bank as gross
operational loss amounts, dates, recoveries, and relevant causal
information for operational loss events occurring at organizations
other than the bank. External operational loss event data may serve a
number of different purposes in a bank's operational risk data and
assessment systems. For example, external operational loss event data
may be a particularly useful input in determining a bank's level of
exposure to operational risk when internal operational loss event data
are limited. In addition, external operational loss event data provide
a means for the bank to understand industry experience and, in turn,
provide a means for the bank to assess the adequacy of its internal
operational loss event data.
While internal and external operational loss event data provide a
historical perspective on operational risk, it is also important that a
bank incorporate forward-looking elements in its operational risk data
and assessment systems. Accordingly, a bank must incorporate a business
environment and internal control factor analysis in its operational
risk data and assessment systems to fully assess its exposure to
operational risk. In principle, a bank with strong internal controls in
a stable business environment would have less exposure to operational
risk than a bank with internal control weaknesses that is growing
rapidly or introducing new products. In this regard, a bank should
identify and assess the level and trends in operational risk and
related control structures at the bank. These assessments should be
current, should be comprehensive across the bank, and should identify
the operational risks facing the bank. The framework established by a
bank to maintain these risk assessments should be sufficiently flexible
to accommodate increasing complexity, new activities, changes in
internal control systems, and an increasing volume of information. A
bank must also periodically compare the results of its prior business
environment and internal control factor assessments against the bank's
actual operational losses incurred in the intervening period.
Similar to business environment and internal control factor
assessments, the results of scenario analysis provide a means for a
bank to incorporate a forward-looking element in its operational risk
data and assessment systems. Under the proposed rule, scenario analysis
is a systematic process of obtaining expert opinions from business
managers and risk management experts to derive reasoned assessments of
the likelihood and loss impact of plausible high-severity operational
losses that may occur at a bank. A bank must establish a systematic
process for determining its methodologies for incorporating scenario
analysis into its operational risk data and assessment systems. As an
input to a bank's operational risk data and assessment systems,
scenario analysis is especially relevant for business lines or loss
event types where internal data, external data, and assessments of the
business environment and internal control factors do not provide a
sufficiently robust estimate of the bank's exposure to operational
risk.
A bank's operational risk data and assessment systems must include
credible, transparent, systematic, and verifiable processes that
incorporate all four operational risk elements. The bank should have
clear standards for the collection and modification of all elements.
The bank should combine these four elements in a manner that most
effectively enables it to quantify its exposure to operational risk.
Operational risk quantification system. A bank must have an
operational risk quantification system that measures its operational
risk exposure using its operational risk data and assessment systems.
The proposed rule defines operational risk exposure as the 99.9th
percentile of the distribution of potential aggregate operational
losses, as generated by the bank's operational risk quantification
system over a one-year horizon (and not incorporating eligible
operational risk offsets or qualifying operational risk mitigants). The
mean of such a total loss distribution is the bank's EOL. The proposed
rule defines EOL as the expected value of the distribution of potential
aggregate operational losses, as generated by the bank's operational
risk quantification system using a one-year horizon. The bank's UOL is
the difference between the bank's operational risk exposure and the
bank's EOL.
As part of its estimation of its operational risk exposure, a bank
must demonstrate that its unit of measure is appropriate for the bank's
range of business activities and the variety of operational loss events
to which it is exposed. The proposed rule defines a unit of measure as
the level (for example, organizational unit or operational loss event
type) at which the bank's operational risk quantification system
generates a separate distribution of potential operational losses. A
bank must also demonstrate that it has not combined business activities
or operational loss events with different risk profiles within the same
loss distribution.
The agencies recognize that operational losses across operational
loss event types and business lines may be related. A bank may use its
internal estimates of dependence among operational losses within and
across business lines and operational loss event types if the bank can
demonstrate to the satisfaction of its primary Federal supervisor that
its process for estimating dependence is sound, robust to a variety of
scenarios, and implemented with integrity, and allows for the
uncertainty surrounding the estimates. The agencies expect that a
bank's assumptions regarding dependence will be conservative given the
uncertainties surrounding dependence modeling for operational risk. If
a bank does not satisfy the requirements surrounding dependence
described above, the bank must sum operational risk exposure estimates
across units of measure to calculate its operational risk exposure.
A bank's chosen unit of measure affects how it should account for
dependence. Explicit assumptions regarding dependence across units of
measure are always necessary to estimate operational risk exposure at
the bank level. However, explicit assumptions regarding dependence
within units of measure are not necessary, and under many circumstances
models assume statistical independence within each unit of measure. The
use of only a few units of
[[Page 55853]]
measure heightens the need to ensure that dependence within units of
measure is suitably reflected in the operational risk exposure
estimate.
In addition, the bank's process for estimating dependence should
provide for ongoing monitoring, recognizing that dependence estimates
can change. The agencies expect that a bank's approach for developing
explicit and objective dependence determinations will improve over
time. As such, the bank should develop a process for assessing
incremental improvements to the approach (for example, through out-of-
sample testing).
A bank must review and update (as appropriate) its operational risk
quantification system whenever the bank becomes aware of information
that may have a material effect on the bank's estimate of operational
risk exposure, but no less frequently than annually.
As described above, the agencies expect a bank using the AMA to
demonstrate that its systems for managing and measuring operational
risk meet established standards, including producing an estimate of
operational risk exposure at the 99.9 percent confidence level.
However, the agencies recognize that, in limited circumstances, there
may not be sufficient data available for a bank to generate a credible
estimate of its own operational risk exposure at the 99.9 percent
confidence level. In these limited circumstances, a bank may propose
use of an alternative operational risk quantification system to that
specified in section 22(h)(3)(i) of the proposed rule, subject to
approval by the bank's primary Federal supervisor. The alternative
approach is not available at the BHC level.
The agencies are not prescribing specific estimation methodologies
under this approach and expect use of an alternative approach to occur
on a very limited basis. A bank proposing to use an alternative
operational risk quantification system must submit a proposal to its
primary Federal supervisor. In evaluating a bank's proposal, the bank's
primary Federal supervisor will review the bank's justification for
requesting use of an alternative approach in light of the bank's size,
complexity, and risk profile. The bank's primary Federal supervisor
will also consider whether the proposed approach results in capital
levels that are commensurate with the bank's operational risk profile,
is sensitive to changes in the bank's risk profile, can be supported
empirically, and allows the bank's board of directors to fulfill its
fiduciary responsibilities to ensure that the bank is adequately
capitalized. Furthermore, the agencies expect a bank using an
alternative operational risk quantification system to adhere to the
qualification requirements outlined in the proposed rule, including
establishment and use of operational risk management processes and data
and assessment systems.
A bank proposing an alternative approach to operational risk based
on an allocation methodology should be aware of certain limitations
associated with use of such an approach. Specifically, the agencies
will not accept an allocation of operational risk capital requirements
that includes non-DI entities or the benefits of diversification across
entities. The exclusion of allocations that include non-DIs is in
recognition that, unlike the cross-guarantee provision of the Federal
Deposit Insurance Act, which provides that a DI is liable for any
losses incurred by the FDIC in connection with the failure of a
commonly controlled DI, there are no statutory provisions requiring
cross-guarantees between a DI and its non-DI affiliates.\30\
Furthermore, depositors and creditors of a DI generally have no legal
recourse to capital funds that are not held by the DI or its affiliate
DIs.
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\30\ 12 U.S.C. 1815(e).
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6. Data Management and Maintenance
A bank must have data management and maintenance systems that
adequately support all aspects of the bank's advanced IRB systems,
operational risk management processes, operational risk data and
assessment systems, operational risk quantification systems, and, to
the extent the bank uses the following systems, the internal models
methodology to counterparty credit risk, double default excessive
correlation detection process, IMA to equity exposures, and IAA to
securitization exposures to ABCP programs (collectively, advanced
systems). The bank's data management and maintenance systems must
ensure the timely and accurate reporting of risk-based capital
requirements. Specifically, a bank must retain sufficient data elements
to permit monitoring, validation, and refinement of the bank's advanced
systems. A bank's data management and maintenance systems should
generally support the proposed rule's qualification requirements
relating to quantification, validation, and control and oversight
mechanisms, as well as the bank's broader risk management and reporting
needs. The precise data elements to be collected would be dictated by
the features and methodologies of the risk measurement and management
systems employed by the bank. To meet the significant data management
challenges presented by the quantification, validation, and control and
oversight requirements of the advanced approaches, a bank must store
its data in an electronic format that allows timely retrieval for
analysis, reporting, and disclosure purposes.
7. Control and Oversight Mechanisms
The consequences of an inaccurate or unreliable advanced system can
be significant, particularly on the calculation of risk-based capital
requirements. Accordingly, bank senior management would be responsible
for ensuring that all advanced system components function effectively
and are in compliance with the qualification requirements of the
advanced approaches. Moreover, the bank's board of directors (or a
designated committee of the board) must evaluate at least annually the
effectiveness of, and approve, the bank's advanced systems.
To support senior management's and the board of directors'
oversight responsibilities, a bank must have an effective system of
controls and oversight that ensures ongoing compliance with the
qualification requirements and maintains the integrity, reliability,
and accuracy of the bank's advanced systems. Banks would have
flexibility in how they achieve integrity in their risk management
systems. They would, however, be expected to follow standard control
principles in their systems such as checks and balances, separation of
duties, appropriateness of incentives, and data integrity assurance,
including that of information purchased from third parties. Moreover,
the oversight process should be sufficiently independent of the
advanced systems' development, implementation, and operation to ensure
the integrity of the component systems. The objective of risk
management system oversight is to ensure that the various systems used
in determining risk-based capital requirements are operating as
intended. The oversight process should draw conclusions on the
soundness of the components of the risk management system, identify
errors and flaws, and recommend corrective action as appropriate.
Validation. A bank must validate its advanced systems on an ongoing
basis. Validation is the set of activities designed to give the
greatest possible assurances of accuracy of the advanced systems.
Validation includes three broad components: (i) Evaluation of the
conceptual soundness of the advanced
[[Page 55854]]
systems, taking into account industry developments; (ii) ongoing
monitoring that includes process verification and comparison of the
bank's internal estimates with relevant internal and external data
sources or results using other estimation techniques (benchmarking);
and (iii) outcomes analysis that includes comparisons of actual
outcomes to the bank's internal estimates by backtesting and other
methods.
Each of these three components of validation must be applied to the
bank's risk rating and segmentation systems, risk parameter
quantification processes, and internal models that are part of the
bank's advanced systems. A sound validation process should take
business cycles into account, and any adjustments for stages of the
economic cycle should be clearly specified in advance and fully
documented as part of the validation policy. Senior management of the
bank should be notified of the validation results and should take
corrective action, where appropriate.
A bank's validation process must be independent of the advanced
systems' development, implementation, and operation, or be subject to
independent assessment of its adequacy and effectiveness. A bank should
ensure that individuals who perform the review are independent--that
is, are not biased in their assessment due to their involvement in the
development, implementation, or operation of the processes or products.
For example, reviews of the internal risk rating and segmentation
systems should be performed by individuals who were not part of the
development, implementation, or maintenance of those systems. In
addition, individuals performing the reviews should possess the
requisite technical skills and expertise to fulfill their mandate.
The first component of validation is evaluating conceptual
soundness, which involves assessing the quality of the design and
construction of a risk measurement or management system. This
evaluation of conceptual soundness should include documentation and
empirical evidence supporting the methods used and the variables
selected in the design and quantification of the bank's advanced
systems. The documentation should also include evidence of an
understanding of the limitations of the systems. The development of
internal risk rating and segmentation systems and their quantification
processes requires banks to adopt methods, choose characteristics, and
make adjustments; each of these actions requires judgment. Validation
should ensure that these judgments are well informed and considered,
and generally include a body of expert opinion. A bank should review
developmental evidence whenever the bank makes material changes in its
advanced systems.
The second component of the validation process for a bank's
advanced systems is ongoing monitoring to confirm that the systems were
implemented appropriately and continue to perform as intended. Such
monitoring involves process verification and benchmarking. Process
verification includes verifying that internal and external data are
accurate and complete and ensuring that internal risk rating and
segmentation systems are being used, monitored, and updated as designed
and that ratings are assigned to wholesale obligors and exposures as
intended, and that appropriate remediation is undertaken if
deficiencies exist.
Benchmarking is the set of activities that uses alternative data
sources or risk assessment approaches to draw inferences about the
correctness of internal risk ratings, segmentations, risk parameter
estimates, or model outputs before outcomes are actually known. For
credit risk ratings, examples of alternative data sources include
independent internal raters (such as loan review), external rating
agencies, wholesale and retail credit risk models developed
independently, or retail credit bureau models. Because it will take
considerable time before outcomes will be available and backtesting is
possible, benchmarking will be a very important validation device.
Benchmarking would be applied to all quantification processes and
internal risk rating and segmentation activities.
Benchmarking allows a bank to compare its estimates with those of
other estimation techniques and data sources. Results of benchmarking
exercises can be a valuable diagnostic tool in identifying potential
weaknesses in a bank's risk quantification system. While benchmarking
activities allow for inferences about the appropriateness of the
quantification processes and internal risk rating and segmentation
systems, they are not the same as backtesting. When differences are
observed between the bank's risk estimates and the benchmark, this
should not necessarily indicate that the internal risk ratings,
segmentation decisions, or risk parameter estimates are in error. The
benchmark itself is an alternative prediction, and the difference may
be due to different data or methods. As part of the benchmarking
exercise, the bank should investigate the source of the differences and
whether the extent of the differences is appropriate.
The third component of the validation process is outcomes analysis,
which is the comparison of the bank's forecasts of risk parameters and
other model outputs with actual outcomes. A bank's outcomes analysis
must include backtesting, which is the comparison of the bank's
forecasts generated by its internal models with actual outcomes during
a sample period not used in model development. In this context,
backtesting is one form of out-of-sample testing. The agencies note
that in other contexts backtesting may refer to in-sample fit, but in-
sample fit analysis is not what the proposed rule requires a bank to do
as part of the advanced approaches validation process.
Actual outcomes would be compared with expected ranges around the
estimated values of the risk parameters and model results. Random
chance and many other factors will make discrepancies between realized
outcomes and the estimated risk parameters inevitable. Therefore the
expected ranges should take into account relevant elements of a bank's
internal risk rating or segmentation processes. For example, depending
on the bank's rating philosophy, year-by-year realized default rates
may be expected to differ significantly from the long-run one-year
average. Also, changes in economic conditions between the historical
data and current period can lead to differences between realizations
and estimates.
Internal audit. A bank must have an internal audit function
independent of business-line management that assesses at least annually
the effectiveness of the controls supporting the bank's advanced
systems. At least annually, internal audit should review the validation
process, including validation procedures, responsibilities, results,
timeliness, and responsiveness to findings. Further, internal audit
should evaluate the depth, scope, and quality of the risk management
system review process and conduct appropriate testing to ensure that
the conclusions of these reviews are well founded. Internal audit must
report its findings at least annually to the bank's board of directors
(or a committee thereof).
Stress testing. A bank must periodically stress test its advanced
systems. Stress testing analysis is a means of understanding how
economic cycles, especially downturns as described by stress scenarios,
affect risk-based capital requirements, including migration across
rating grades or segments and the credit risk mitigation
[[Page 55855]]
benefits of double default treatment. Under the proposed rule, changes
in borrower credit quality will lead to changes in risk-based capital
requirements. Because credit quality changes typically reflect changing
economic conditions, risk-based capital requirements may also vary with
the economic cycle. During an economic downturn, risk-based capital
requirements would increase if wholesale obligors or retail exposures
migrate toward lower credit quality ratings or segments.
Supervisors expect that banks will manage their regulatory capital
position so that they remain at least adequately capitalized during all
phases of the economic cycle. A bank that is able to credibly estimate
regulatory capital levels during a downturn can be more confident of
appropriately managing regulatory capital. Stress testing analysis
consists of identifying a stress scenario and then translating the
scenario into its effect on the levels of key performance measures,
including regulatory capital ratios.
Banks should use a range of plausible but severe scenarios and
methods when stress testing to manage regulatory capital. Scenarios
could be historical, hypothetical, or model-based. Key variables
specified in a scenario could include, for example, interest rates,
transition matrices (ratings and score-band segments), asset values,
credit spreads, market liquidity, economic growth rates, inflation
rates, exchange rates, or unemployment rates. A bank may choose to have
scenarios apply to an entire portfolio, or it may identify scenarios
specific to various sub-portfolios. The severity of the stress
scenarios should be consistent with the periodic economic downturns
experienced in the bank's market areas. Such scenarios may be less
severe than those used for other purposes, such as testing a bank's
solvency.
The scope of stress testing analysis should be broad and include
all material portfolios. The time horizon of the analysis should be
consistent with the specifics of the scenario and should be long enough
to measure the material effects of the scenario on key performance
measures. For example, if a scenario such as a historical recession has
material income and segment or ratings migration effects over two
years, the appropriate time horizon is at least two years.
8. Documentation
A bank must document adequately all material aspects of its
advanced systems, including but not limited to the internal risk rating
and segmentation systems, risk parameter quantification processes,
model design, assumptions, and validation results. The guiding
principle governing documentation is that it should support the
requirements for the quantification, validation, and control and
oversight mechanisms as well as the bank's broader risk management and
reporting needs. Documentation is also critical to the supervisory
oversight process.
The bank should document the rationale for all material assumptions
underpinning its chosen analytical frameworks, including the choice of
inputs, distributional assumptions, and weighting of quantitative and
qualitative elements. The bank also should document and justify any
subsequent changes to these assumptions.
C. Ongoing Qualification
An advanced approaches bank must meet the qualification
requirements on an ongoing basis. Banks are expected to improve their
advanced systems as they improve data gathering capabilities and as
industry practice evolves. To facilitate the supervisory oversight of
such systems changes, a bank must notify its primary Federal supervisor
when it makes a change to its advanced systems that results in a
material change in the bank's risk-weighted asset amount for an
exposure type, or when the bank makes any significant change to its
modeling assumptions.
Due to the advanced approaches' rigorous systems requirements, a
core or opt-in bank that merges with or acquires another company that
does not calculate risk-based capital requirements using the advanced
approaches might not be able to use the advanced approaches immediately
for the merged or acquired company's exposures. Therefore, the proposed
rule would permit a core or opt-in bank to use the general risk-based
capital rules to compute the risk-weighted assets and associated
capital for the merged or acquired company's exposures for up to 24
months following the calendar quarter during which the merger or
acquisition consummates.
Any ALLL associated with the acquired company's exposures may be
included in the acquiring bank's tier 2 capital up to 1.25 percent of
the acquired company's risk-weighted assets. Such ALLL would be
excluded from the acquiring bank's eligible credit reserves. The risk-
weighted assets of the acquired company would not be included in the
acquiring bank's credit-risk-weighted assets but would be included in
the acquiring bank's total risk-weighted assets. Any amount of the
acquired company's ALLL that was eliminated in accounting for the
acquisition would not be included in the acquiring bank's regulatory
capital. An acquiring bank using the general risk-based capital rules
for acquired exposures would be required to disclose publicly the
amounts of risk-weighted assets and qualifying capital calculated under
the general risk-based capital rules with respect to the acquired
company and under the proposed rule for the acquiring bank.
Similarly, due to the substantial infrastructure requirements of
the proposed rule, a core or opt-in bank that merges with or acquires
another core or opt-in bank might not be able to apply its own version
of the advanced approaches immediately to the acquired bank's
exposures. Accordingly, the proposed rule permits a core or opt-in bank
that merges with or acquires another core or opt-in bank to use the
acquired bank's advanced approaches to determine the risk-weighted
asset amounts for, and deductions from capital associated with, the
acquired bank's exposures for up to 24 months following the calendar
quarter during which the merger or acquisition consummates.
In all mergers and acquisitions involving a core or opt-in bank,
the acquiring bank must submit an implementation plan for using
advanced approaches for the merged or acquired company to its primary
Federal supervisor within 30 days of consummating the merger or
acquisition. A bank's primary Federal supervisor may extend the
transition period for mergers or acquisitions for up to an additional
12 months. The primary Federal supervisor of the bank will monitor the
merger or acquisition to determine whether the application of the
general risk-based capital rules by the acquired company produces
appropriate risk weights for the assets of the acquired company in
light of the overall risk profile of the combined bank.
Question 20: The agencies seek comment on the appropriateness of
the 24-month and 30-day time frames for addressing the merger and
acquisition transition situations advanced approaches banks may face.
If a bank that uses the advanced approaches to calculate its risk-
based capital requirements falls out of compliance with the
qualification requirements, the bank must establish a plan satisfactory
to its primary Federal supervisor to return to compliance with the
qualification requirements. Such a bank also must disclose to the
public its failure to comply with the qualification requirements
promptly after receiving notice of non-compliance from its
[[Page 55856]]
primary Federal supervisor. If the bank's primary Federal supervisor
determines that the bank's risk-based capital requirements are not
commensurate with the bank's credit, market, operational, or other
risks, it may require the bank to calculate its risk-based capital
requirements using the general risk-based capital rules or a modified
form of the advanced approaches (for example, with fixed supervisory
risk parameters).
IV. Calculation of Tier 1 Capital and Total Qualifying Capital
The proposed rule maintains the minimum risk-based capital ratio
requirements of 4.0 percent tier 1 capital to total risk-weighted
assets and 8.0 percent total qualifying capital to total risk-weighted
assets. Under the proposed rule, a bank's total qualifying capital is
the sum of its tier 1 (core) capital elements and tier 2 (supplemental)
capital elements, subject to various limits and restrictions, minus
certain deductions (adjustments). The agencies are not restating the
elements of tier 1 and tier 2 capital in this proposed rule. Those
capital elements generally remain as they are currently in the general
risk-based capital rules.\31\ The agencies have provided proposed
regulatory text for, and the following discussion of, proposed
adjustments to the capital elements for purposes of the advanced
approaches.
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\31\ See 12 CFR part 3, Appendix A, Sec. 2 (national banks); 12
CFR part 208, Appendix A, Sec. II (state member banks); 12 CFR part
225, Appendix A, Sec. II (bank holding companies); 12 CFR part 325,
Appendix A (state nonmember banks); and 12 CFR 567.5 (savings
associations).
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The agencies are considering restating the elements of tier 1 and
tier 2 capital, with any necessary conforming and technical amendments,
in any final rules that are issued regarding this proposed framework so
that a bank using the advanced approaches would have a single,
comprehensive regulatory text that describes both the numerator and
denominator of the bank's minimum risk-based capital ratios. The
agencies decided not to set forth the capital elements in this proposed
rule so that commenters would be able to focus attention on the parts
of the risk-based capital framework that the agencies propose to amend.
Question 21: Commenters are encouraged to provide views on the proposed
adjustments to the components of the risk-based capital numerator as
described below. Commenters also may provide views on numerator-related
issues that they believe would be useful to the agencies' consideration
of the proposed rule.
After identifying the elements of tier 1 and tier 2 capital, a bank
would make certain adjustments to determine its tier 1 capital and
total qualifying capital (that is, the numerator of the total risk-
based capital ratio). Some of these adjustments would be made only to
the tier 1 portion of the capital base. Other adjustments would be made
50 percent from tier 1 capital and 50 percent from tier 2 capital.\32\
Under the proposed rule, a bank must still have at least 50 percent of
its total qualifying capital in the form of tier 1 capital.
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\32\ If the amount deductible from tier 2 capital exceeds the
bank's actual tier 2 capital, however, the bank must deduct the
shortfall amount from tier 1 capital.
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The bank would continue to deduct from tier 1 capital goodwill,
other intangible assets, and deferred tax assets to the same extent
that those assets are currently required to be deducted from tier 1
capital under the general risk-based capital rules. Thus, all goodwill
would be deducted from tier 1 capital. Qualifying intangible assets--
including mortgage servicing assets, non-mortgage servicing assets, and
purchased credit card relationships--that meet the conditions and
limits in the general risk-based capital rules would not have to be
deducted from tier 1 capital. Likewise, deferred tax assets that are
dependent upon future taxable income and that meet the valuation
requirements and limits in the general risk-based capital rules would
not have to be deducted from tier 1 capital.\33\
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\33\ See 12 CFR part 3, Sec. 2 (national banks); 12 CFR part
208, Appendix A, Sec. 2L3II (state member banks); 12 CFR part 225,
Appendix A, Sec. II (bank holding companies); 12 CFR part 325,
Appendix A, Sec. II (state nonmember banks). OTS existing rules are
formulated differently, but include similar deductions. Under OTS
rules, for example, goodwill is included within the definition of
``intangible assets'' and is deducted from tier 1 (core) capital
along with other intangible assets. See 12 CFR 567.1 and
567.5(a)(2)(i). Similarly, purchased credit card relationships and
mortgage and non-mortgage servicing assets are included in capital
to the same extent as the other agencies' rules. See 12 CFR
567.5(a)(2)(ii) and 567.12. The deduction of deferred tax assets is
discussed in Thrift Bulletin 56.
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Under the general risk-based capital rules, a bank also must deduct
from its tier 1 capital certain percentages of the adjusted carrying
value of its nonfinancial equity investments. An advanced approaches
bank would no longer be required to make this deduction. Instead, the
bank's equity exposures would be subject to the equity treatment in
part VI of the proposed rule and described in section V.F. of this
preamble.\34\
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\34\ By contrast, OTS rules require the deduction of equity
investments from total capital. 12 CFR 567.5(c)(2)(ii). ``Equity
investments'' are defined to include (i) investments in equity
securities (other than investments in subsidiaries, equity
investments that are permissible for national banks, indirect
ownership interests in certain pools of assets (for example, mutual
funds), Federal Home Loan Bank stock and Federal Reserve Bank
stock); and (ii) investments in certain real property. 12 CFR 567.1.
Savings associations applying the proposed rule would not be
required to deduct investments in equity securities. Instead, such
investments would be subject to the equity treatment in part VI of
the proposed rule. Equity investments in real estate would continue
to be deducted to the same extent as under the current rules.
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Under the general risk-based capital rules, a bank is allowed to
include in tier 2 capital its ALLL up to 1.25 percent of risk-weighted
assets (net of certain deductions). Amounts of ALLL in excess of this
limit, as well as allocated transfer risk reserves, may be deducted
from the gross amount of risk-weighted assets.
Under the proposed framework, as noted above, the ALLL is treated
differently. The proposed rule includes a methodology for adjusting
risk-based capital requirements based on a comparison of the bank's
eligible credit reserves to its ECL. The proposed rule defines eligible
credit reserves as all general allowances, including the ALLL, that
have been established through a charge against earnings to absorb
credit losses associated with on- or off-balance sheet wholesale and
retail exposures. Eligible credit reserves would not include allocated
transfer risk reserves established pursuant to 12 U.S.C. 3904\35\ and
other specific reserves created against recognized losses.
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\35\ 12 U.S.C. 3904 does not apply to savings associations
regulated by the OTS. As a result, the OTS rule will not refer to
allocated transfer risk reserves.
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The proposed rule defines a bank's total ECL as the sum of ECL for
all wholesale and retail exposures other than exposures to which the
bank has applied the double default treatment (described below). The
bank's ECL for a wholesale exposure to a non-defaulted obligor or a
non-defaulted retail segment is the product of PD, ELGD, and EAD for
the exposure or segment. The bank's ECL for a wholesale exposure to a
defaulted obligor or a defaulted retail segment is equal to the bank's
impairment estimate for ALLL purposes for the exposure or segment.
The proposed method of measuring ECL for non-defaulted exposures is
different than the proposed method of measuring ECL for defaulted
exposures. For non-defaulted exposures, ECL depends directly on ELGD
and hence would reflect economic losses, including the cost of carry
and direct and indirect workout expenses. In contrast, for defaulted
exposures, ECL is based on accounting measures of credit
[[Page 55857]]
loss incorporated into a bank's charge-off and reserving practices.
The agencies believe that, for defaulted exposures, any difference
between a bank's best estimate of economic losses and its impairment
estimate for ALLL purposes is likely to be small. As a result, the
agencies are proposing to use a bank's ALLL impairment estimate in the
determination of ECL for defaulted exposures to reduce implementation
burden for banks. The agencies recognize that this proposed treatment
would require a bank to specify how much of its ALLL is attributable to
defaulted exposures, and that a bank still would need to capture all
material economic losses on defaulted exposures when building its
databases for estimating ELGDs and LGDs for non-defaulted exposures.
Question 22: The agencies seek comment on the proposed ECL approach for
defaulted exposures as well as on an alternative treatment, under which
ECL for a defaulted exposure would be calculated as the bank's current
carrying value of the exposure multiplied by the bank's best estimate
of the expected economic loss rate associated with the exposure
(measured relative to the current carrying value), that would be more
consistent with the proposed treatment of ECL for non-defaulted
exposures. The agencies also seek comment on whether these two
approaches would likely produce materially different ECL estimates for
defaulted exposures. In addition, the agencies seek comment on the
appropriate measure of ECL for assets held at fair value with gains and
losses flowing through earnings.
A bank must compare the total dollar amount of its ECL to its
eligible credit reserves. If there is a shortfall of eligible credit
reserves compared to total ECL, the bank would deduct 50 percent of the
shortfall from tier 1 capital and 50 percent from tier 2 capital. If
eligible credit reserves exceed total ECL, the excess portion of
eligible credit reserves may be included in tier 2 capital up to 0.6
percent of credit-risk-weighted assets. The proposed rule defines
credit-risk-weighted assets as 1.06 multiplied by the sum of total
wholesale and retail risk-weighted assets, risk-weighted assets for
securitization exposures, and risk-weighted assets for equity
exposures.
A bank must deduct from tier 1 capital any increase in the bank's
equity capital at the inception of a securitization transaction (gain-
on-sale), other than an increase in equity capital that results from
the bank's receipt of cash in connection with the securitization. The
agencies have designed this deduction to offset accounting treatments
that produce an increase in a bank's equity capital and tier 1 capital
at the inception of a securitization--for example, a gain attributable
to a CEIO that results from Financial Accounting Standard (FAS) 140
accounting treatment for the sale of underlying exposures to a
securitization special purpose entity (SPE). Over time, as the bank,
from an accounting perspective, realizes the increase in equity capital
and tier 1 capital that was booked at the inception of the
securitization through actual receipt of cash flows, the amount of the
required deduction would shrink accordingly.
Under the general risk-based capital rules,\36\ a bank must deduct
CEIOs, whether purchased or retained, from tier 1 capital to the extent
that the CEIOs exceed 25 percent of the bank's tier 1 capital. Under
the proposed rule, a bank must deduct CEIOs from tier 1 capital to the
extent they represent gain-on-sale, and must deduct any remaining CEIOs
50 percent from tier 1 capital and 50 percent from tier 2 capital.
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\36\ See 12 CFR part 3, Appendix A, section 2(c)(4) (national
banks); 12 CFR part 208, Appendix A, section I.B.1.c. (state member
banks); 12 CFR part 225, Appendix A, section I.B.1.c. (bank holding
companies); 12 CFR part 325, Appendix A, section I.B.5. (state
nonmember banks); 12 CFR 567.5(a)(2)(iii) (savings associations).
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Under the proposed rule, certain other securitization exposures
also would be deducted from tier 1 and tier 2 capital. These exposures
include, for example, securitization exposures that have an applicable
external rating (defined below) that is more than one category below
investment grade (for example, below BB) and most subordinated unrated
securitization exposures. When a bank must deduct a securitization
exposure (other than gain-on-sale) from regulatory capital, the bank
must take the deduction 50 percent from tier 1 capital and 50 percent
from tier 2 capital. Moreover, a bank may calculate any deductions from
regulatory capital with respect to a securitization exposure (including
after-tax gain-on-sale) net of any deferred tax liabilities associated
with the exposure.
The proposed rule also requires a bank to deduct the bank's
exposure on certain unsettled and failed capital markets transactions
50 percent from tier 1 capital and 50 percent from tier 2 capital, as
discussed in more detail below in section V.D. of the preamble.
The agencies note that investments in unconsolidated banking and
finance subsidiaries and reciprocal holdings of bank capital
instruments would continue to be deducted from regulatory capital as
described in the general risk-based capital rules. Under the agencies'
current rules, a national or state bank that controls or holds an
interest in a financial subsidiary does not consolidate the assets and
liabilities of the financial subsidiary with those of the bank for
risk-based capital purposes. In addition, the bank must deduct its
equity investment (including retained earnings) in the financial
subsidiary from regulatory capital--at least 50 percent from tier 1
capital and up to 50 percent from tier 2 capital.\37\ A BHC generally
does not deconsolidate the assets and liabilities of the financial
subsidiaries of the BHC's subsidiary banks and does not deduct from its
regulatory capital the equity investments of its subsidiary banks in
financial subsidiaries. Rather, a BHC generally fully consolidates the
financial subsidiaries of its subsidiary banks. These treatments would
continue under the proposed rule.
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\37\ See 12 CFR 5.39(h)(1) (national banks); 12 CFR 208.73(a)
(state member banks); 12 CFR part 325, Appendix A, section I.B.2.
(state nonmember banks). Again, OTS rules are formulated
differently. For example, OTS rules do not use the terms
``unconsolidated banking and finance subsidiary'' or ``financial
subsidiary.'' Rather, as required by section 5(t)(5) of the Home
Owners' Loan Act (HOLA), equity and debt investments in non-
includable subsidiaries (generally subsidiaries that are engaged in
activities that are not permissible for a national bank) are
deducted from assets and tier 1 (core) capital. 12 CFR
567.5(a)(2)(iv) and (v). As required by HOLA, OTS will continue to
deduct non-includable subsidiaries. Reciprocal holdings of bank
capital instruments are deducted from a savings association's total
capital under 12 CFR 567.5(c)(2).
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For BHCs with consolidated insurance underwriting subsidiaries that
are functionally regulated (or subject to comparable supervision and
minimum regulatory capital requirements in their home jurisdiction),
the following treatment would apply. The assets and liabilities of the
subsidiary would be consolidated for purposes of determining the BHC's
risk-weighted assets. However, the BHC must deduct from tier 1 capital
an amount equal to the insurance underwriting subsidiary's minimum
regulatory capital requirement as determined by its functional (or
equivalent) regulator. For U.S. regulated insurance subsidiaries, this
amount generally would be 200 percent of the subsidiary's Authorized
Control Level as established by the appropriate state insurance
regulator.
This approach with respect to functionally-regulated consolidated
insurance underwriting subsidiaries is different from the New Accord,
which broadly endorses a deconsolidation and deduction approach for
insurance subsidiaries. The Board believes a full deconsolidation and
deduction
[[Page 55858]]
approach does not fully capture the risk in insurance underwriting
subsidiaries at the consolidated BHC level and, thus, has proposed the
consolidation and deduction approach described above. Question 23: The
Board seeks comment on this proposed treatment and in particular on how
a minimum insurance regulatory capital proxy for tier 1 deduction
purposes should be determined for insurance underwriting subsidiaries
that are not subject to U.S. functional regulation.
A March 10, 2005, final rule issued by the Board defined restricted
core capital elements for BHCs and generally limited restricted core
capital elements for internationally active banking organizations to 15
percent of the sum of all core capital elements net of goodwill less
any associated deferred tax liability.\38\ Restricted core capital
elements are defined as qualifying cumulative perpetual preferred stock
(and related surplus), minority interest related to qualifying
cumulative perpetual preferred stock directly issued by a consolidated
DI or foreign bank subsidiary, minority interest related to qualifying
common or qualifying perpetual preferred stock issued by a consolidated
subsidiary that is neither a DI nor a foreign bank, and qualifying
trust preferred securities. The final rule defined an internationally
active banking organization to be a BHC that (i) as of its most recent
year-end FR Y-9C reports total consolidated assets equal to $250
billion or more or (ii) on a consolidated basis, reports total on-
balance sheet foreign exposure of $10 billion or more in its filing of
the most recent year-end FFIEC 009 Country Exposure Report. The Board
intends to change the definition of an internationally active banking
organization in the Board's capital adequacy guidelines for BHCs to
make it consistent with the definition of a core bank. This change
would be less restrictive on BHCs because the BHC threshold in this
proposed rule uses total consolidated assets excluding insurance rather
than total consolidated assets including insurance.
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\38\ 70 FR 11827 (Mar. 10, 2005). The final rule also allowed
internationally active banking organizations to include restricted
core capital elements in their tier 1 capital up to 25 percent of
the sum of all core capital elements net of goodwill less associated
deferred tax liability so long as any amounts of restricted core
capital elements in excess of the 15 percent limit were in the form
of mandatory convertible preferred securities.
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V. Calculation of Risk-Weighted Assets
A bank's total risk-weighted assets would be the sum of its credit
risk-weighted assets and risk-weighted assets for operational risk,
minus the sum of its excess eligible credit reserves (that is, its
eligible credit reserves in excess of its total ECL) not included in
tier 2 capital and allocated transfer risk reserves.
A. Categorization of Exposures
To calculate credit risk-weighted assets, a bank must group its
exposures into four general categories: wholesale, retail,
securitization, and equity. It must also identify assets not included
in an exposure category and any non-material portfolios of exposures to
which the bank elects not to apply the IRB framework. In order to
exclude a portfolio from the IRB framework, a bank must demonstrate to
the satisfaction of its primary Federal supervisor that the portfolio
(when combined with all other portfolios of exposures that the bank
seeks to exclude from the IRB framework) is not material to the bank.
1. Wholesale Exposures
The proposed rule defines a wholesale exposure as a credit exposure
to a company, individual, sovereign or governmental entity (other than
a securitization exposure, retail exposure, or equity exposure).\39\
The term ``company'' is broadly defined to mean a corporation,
partnership, limited liability company, depository institution,
business trust, SPE, association, or similar organization. Examples of
a wholesale exposure include: (i) A non-tranched guarantee issued by a
bank on behalf of a company; \40\ (ii) a repo-style transaction entered
into by a bank with a company and any other transaction in which a bank
posts collateral to a company and faces counterparty credit risk; (iii)
an exposure that the bank treats as a covered position under the MRA
for which there is a counterparty credit risk charge in section 32 of
the proposed rule; (iv) a sale of corporate loans by a bank to a third
party in which the bank retains full recourse; (v) an OTC derivative
contract entered into by a bank with a company; (vi) an exposure to an
individual that is not managed by the bank as part of a segment of
exposures with homogeneous risk characteristics; and (vii) a commercial
lease.
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\39\ The proposed rule excludes from the definition of a
wholesale exposure certain pre-sold one-to-four family residential
construction loans and certain multifamily residential loans. The
treatment of such loans is discussed below in section V.B.5. of the
preamble.
\40\ As described below, tranched guarantees (like most
transactions that involve a tranching of credit risk) generally
would be securitization exposures under this proposal. The proposal
defines a guarantee broadly to include almost any transaction (other
than a credit derivative executed under standard industry credit
derivative documentation) that involves the transfer of the credit
risk of an exposure from one party to another party. This definition
of guarantee generally would include, for example, a credit spread
option under which a bank has agreed to make payments to its
counterparty in the event of an increase in the credit spread
associated with a particular reference obligation issued by a
company.
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The agencies are proposing two subcategories of wholesale
exposures--HVCRE exposures and non-HVCRE exposures. Under the proposed
rule, HVCRE exposures would be subject to a separate IRB risk-based
capital formula that would produce a higher risk-based capital
requirement for a given set of risk parameters than the IRB risk-based
capital formula for non-HVCRE wholesale exposures. An HVCRE exposure is
defined as a credit facility that finances or has financed the
acquisition, development, or construction of real property, excluding
facilities used to finance (i) one- to four-family residential
properties or (ii) commercial real estate projects where: (A) The
exposure's LTV ratio is less than or equal to the applicable maximum
supervisory LTV ratio in the real estate lending standards of the
agencies; \41\ (B) the borrower has contributed capital to the project
in the form of cash or unencumbered readily marketable assets (or has
paid development expenses out-of-pocket) of at least 15 percent of the
real estate's appraised ``as completed'' value; and (C) the borrower
contributed the amount of capital required before the bank advances
funds under the credit facility, and the capital contributed by the
borrower or internally generated by the project is contractually
required to remain in the project throughout the life of the project.
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\41\ 12 CFR part 34, Subpart D (OCC); 12 CFR part 208, Appendix
C (Board); 12 CFR part 365, Subpart D (FDIC); and 12 CFR 560.100-
560.101 (OTS).
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Once an exposure is determined to be HVCRE, it would remain an
HVCRE exposure until paid in full, sold, or converted to permanent
financing. After considering comments received on the ANPR, the
agencies are proposing to retain a separate IRB risk-based capital
formula for HVCRE exposures in recognition of the high levels of
systematic risk inherent in some of these exposures. The agencies
believe that the revised definition of HVCRE in the proposed rule
appropriately identifies exposures that are particularly susceptible to
systematic risk. Question 24: The agencies seek comment on how to
strike the appropriate balance between the enhanced risk sensitivity
and marginally higher risk-based capital
[[Page 55859]]
requirements obtained by separating HVCRE exposures from other
wholesale exposures and the additional complexity the separation
entails.
The New Accord identifies five sub-classes of specialized lending
for which the primary source of repayment of the obligation is the
income generated by the financed asset(s) rather than the independent
capacity of a broader commercial enterprise. The sub-classes are
project finance, object finance, commodities finance, income-producing
real estate, and HVCRE. The New Accord provides a methodology to
accommodate banks that cannot meet the requirements for the estimation
of PD for these exposure types. The sophisticated banks that would
apply the advanced approaches in the United States should be able to
estimate risk parameters for specialized lending exposures, and
therefore the agencies are not proposing a separate treatment for
specialized lending beyond the separate IRB risk-based capital formula
for HVCRE exposures specified in the New Accord.
In contrast to the New Accord, the agencies are not including in
this proposed rule an adjustment that would result in a lower risk
weight for a loan to a small- and medium-size enterprise (SME) that has
the same risk parameter values as a loan to a larger firm. The agencies
are not aware of compelling evidence that smaller firms with the same
PD and LGD as larger firms are subject to less systematic risk.
Question 25: The agencies request comment and supporting evidence on
the consistency of the proposed treatment with the underlying riskiness
of SME portfolios. Further, the agencies request comment on any
competitive issues that this aspect of the proposed rule may cause for
U.S. banks.
2. Retail Exposures
Under the proposed rule, a retail exposure would generally include
exposures (other than securitization exposures or equity exposures) to
an individual or small business that are managed as part of a segment
of similar exposures, that is, not on an individual-exposure basis.
Under the proposed rule, there are three subcategories of retail
exposure: (i) Residential mortgage exposures; (ii) QREs; and (iii)
other retail exposures. The agencies propose generally to define
residential mortgage exposure as an exposure that is primarily secured
by a first or subsequent lien on one-to-four-family residential
property.\42\ This includes both term loans and revolving home equity
lines of credit (HELOCs). An exposure primarily secured by a first or
subsequent lien on residential property that is not one-to-four family
would also be included as a residential mortgage exposure as long as
the exposure has both an original and current outstanding amount of no
more than $1 million. There would be no upper limit on the size of an
exposure that is secured by one-to-four-family residential properties.
To be a residential mortgage exposure, the bank must manage the
exposure as part of a segment of exposures with homogeneous risk
characteristics. Residential mortgage loans that are managed on an
individual basis, rather than managed as part of a segment, would be
categorized as wholesale exposures.
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\42\ The proposed rule excludes from the definition of a
residential mortgage exposure certain pre-sold one-to-four family
residential construction loans and certain multi-family residential
loans. The treatment of such loans is discussed below in section
V.B.5. of the preamble.
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QREs would be defined as exposures to individuals that are (i)
revolving, unsecured, and unconditionally cancelable by the bank to the
fullest extent permitted by Federal law; (ii) have a maximum exposure
amount (drawn plus undrawn) of up to $100,000; and (iii) are managed as
part of a segment with homogeneous risk characteristics. In practice,
QREs typically would include exposures where customers' outstanding
borrowings are permitted to fluctuate based on their decisions to
borrow and repay, up to a limit established by the bank. Most credit
card exposures to individuals and overdraft lines on individual
checking accounts would be QREs.
The category of other retail exposures would include two types of
exposures. First, all exposures to individuals for non-business
purposes (other than residential mortgage exposures and QREs) that are
managed as part of a segment of similar exposures would be other retail
exposures. Such exposures may include personal term loans, margin
loans, auto loans and leases, credit card accounts with credit lines
above $100,000, and student loans. The agencies are not proposing an
upper limit on the size of these types of retail exposures to
individuals. Second, exposures to individuals or companies for business
purposes (other than residential mortgage exposures and QREs), up to a
single-borrower exposure threshold of $1 million, that are managed as
part of a segment of similar exposures would be other retail exposures.
For the purpose of assessing exposure to a single borrower, the bank
would aggregate all business exposures to a particular legal entity and
its affiliates that are consolidated under GAAP. If that legal entity
is a natural person, any consumer loans (for example, personal credit
card loans or mortgage loans) to that borrower would not be part of the
aggregate. A bank could distinguish a consumer loan from a business
loan by the loan department through which the loan is made. Exposures
to a borrower for business purposes primarily secured by residential
property would count toward the $1 million single-borrower other retail
business exposure threshold.\43\
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\43\ The proposed rule excludes from the definition of an other
retail exposure certain pre-sold one-to-four family residential
construction loans and certain multi-family residential loans. The
treatment of such loans is discussed below in section V.B.5. of the
preamble.
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The residual value portion of a retail lease exposure is excluded
from the definition of an other retail exposure. A bank would assign
the residual value portion of a retail lease exposure a risk-weighted
asset amount equal to its residual value as described in section 31 of
the proposed rule.
3. Securitization Exposures
The proposed rule defines a securitization exposure as an on-
balance sheet or off-balance sheet credit exposure that arises from a
traditional or synthetic securitization. A traditional securitization
is a transaction in which (i) all or a portion of the credit risk of
one or more underlying exposures is transferred to one or more third
parties other than through the use of credit derivatives or guarantees;
(ii) the credit risk associated with the underlying exposures has been
separated into at least two tranches reflecting different levels of
seniority; (iii) performance of the securitization exposures depends on
the performance of the underlying exposures; and (iv) all or
substantially all of the underlying exposures are financial exposures.
Examples of financial exposures are loans, commitments, receivables,
asset-backed securities, mortgage-backed securities, corporate bonds,
equity securities, or credit derivatives. For purposes of the proposed
rule, mortgage-backed pass-through securities guaranteed by Fannie Mae
or Freddie Mac (whether or not issued out of a structure that tranches
credit risk) also would be securitization exposures.\44\
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\44\ In addition, margin loans and other credit exposures to
personal investment companies, all or substantially all of whose
assets are financial exposures, typically would meet the definition
of a securitization exposure.
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[[Page 55860]]
A synthetic securitization is a transaction in which (i) all or a
portion of the credit risk of one or more underlying exposures is
transferred to one or more third parties through the use of one or more
credit derivatives or guarantees (other than a guarantee that transfers
only the credit risk of an individual retail exposure); (ii) the credit
risk associated with the underlying exposures has been separated into
at least two tranches reflecting different levels of seniority; (iii)
performance of the securitization exposures depends on the performance
of the underlying exposures; and (iv) all or substantially all of the
underlying exposures are financial exposures. Accordingly, the proposed
definition of a securitization exposure would include tranched cover or
guarantee arrangements--that is, arrangements in which an entity
transfers a portion of the credit risk of an underlying exposure to one
or more other guarantors or credit derivative providers but also
retains a portion of the credit risk, where the risk transferred and
the risk retained are of different seniority levels.\45\
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\45\ If a bank purchases an asset-backed security issued by a
securitization SPE and purchases a credit derivative to protect
itself from credit losses associated with the asset-backed security,
the purchase of the credit derivative by the investing bank does not
turn the traditional securitization into a synthetic securitization.
Instead, under the proposal, the investing bank would be viewed as
having purchased a traditional securitization exposure and would
reflect the CRM benefits of the credit derivative through the
securitization CRM rules described later in the preamble and in
section 46 of the proposed rule.
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Provided that there is a tranching of credit risk, securitization
exposures also could include, among other things, asset-backed and
mortgage-backed securities; loans, lines of credit, liquidity
facilities, and financial standby letters of credit; credit derivatives
and guarantees; loan servicing assets; servicer cash advance
facilities; reserve accounts; credit-enhancing representations and
warranties; and CEIOs. Securitization exposures also could include
assets sold with retained tranched recourse. Both the designation of
exposures as securitization exposures and the calculation of risk-based
capital requirements for securitization exposures will be guided by the
economic substance of a transaction rather than its legal form.
As noted above, for a transaction to constitute a securitization
transaction under the proposed rule, all or substantially all of the
underlying exposures must be financial exposures. The proposed rule
includes this requirement because the proposed securitization framework
was designed to address the tranching of the credit risk of exposures
to which the IRB framework can be applied. Accordingly, a specialized
loan to finance the construction or acquisition of large-scale projects
(for example, airports and power plants), objects (for example, ships,
aircraft, or satellites), or commodities (for example, reserves,
inventories, precious metals, oil, or natural gas) generally would not
be a securitization exposure because the assets backing the loan
typically would be nonfinancial assets (the facility, object, or
commodity being financed). In addition, although some structured
transactions involving income-producing real estate or HVCRE can
resemble securitizations, these transactions generally would not be
securitizations because the underlying exposure would be real estate.
Consequently, exposures resulting from the tranching of the risks of
nonfinancial assets are not subject to the proposed rule's
securitization framework, but generally are subject to the proposal's
rules for wholesale exposures. Question 26: The agencies request
comment on the appropriate treatment of tranched exposures to a mixed
pool of financial and non-financial underlying exposures. The agencies
specifically are interested in the views of commenters as to whether
the requirement that all or substantially all of the underlying
exposures of a securitization be financial exposures should be softened
to require only that some lesser portion of the underlying exposures be
financial exposures.
4. Equity Exposures
The proposed rule defines an equity exposure to mean:
(i) A security or instrument whether voting or non-voting that
represents a direct or indirect ownership interest in, and a residual
claim on, the assets and income of a company, unless: (A) The issuing
company is consolidated with the bank under GAAP; (B) the bank is
required to deduct the ownership interest from tier 1 or tier 2
capital; (C) the ownership interest is redeemable; (D) the ownership
interest incorporates a payment or other similar obligation on the part
of the issuing company (such as an obligation to pay periodic
interest); or (E) the ownership interest is a securitization exposure.
(ii) A security or instrument that is mandatorily convertible into
a security or instrument described in (i).
(iii) An option or warrant that is exercisable for a security or
instrument described in (i).
(iv) Any other security or instrument (other than a securitization
exposure) to the extent the return on the security or instrument is
based on the performance of security or instrument described in (i).
For example, a short position in an equity security or a total return
equity swap would be characterized as an equity exposure.
Nonconvertible term or perpetual preferred stock generally would be
considered wholesale exposures rather than equity exposures. Financial
instruments that are convertible into an equity exposure only at the
option of the holder or issuer also generally would be considered
wholesale exposures rather than equity exposures provided that the
conversion terms do not expose the bank to the risk of losses arising
from price movements in that equity exposure. Upon conversion, the
instrument would be treated as an equity exposure.
The agencies note that, as a general matter, each of a bank's
exposures will fit in one and only one exposure category. One principal
exception to this rule is that equity derivatives generally will meet
the definition of an equity exposure (because of the bank's exposure to
the underlying equity security) and the definition of a wholesale
exposure (because of the bank's credit risk exposure to the
counterparty). In such cases, as discussed in more detail below, the
bank's risk-based capital requirement for the derivative generally
would be the sum of its risk-based capital requirement for the
derivative counterparty credit risk and for the underlying exposure.
5. Boundary Between Operational Risk and Other Risks
With the introduction of an explicit risk-based capital requirement
for operational risk, issues arise about the proper treatment of
operational losses that could also be attributed to either credit risk
or market risk. The agencies recognize that these boundary issues are
important and have significant implications for how banks would compile
loss data sets and compute risk-based capital requirements under the
proposed rule. Consistent with the treatment in the New Accord, the
agencies propose treating operational losses that are related to market
risk as operational losses for purposes of calculating risk-based
capital requirements under this proposed rule. For example, losses
incurred from a failure of bank personnel to properly execute a stop
loss order, from trading fraud, or from a bank selling a security
[[Page 55861]]
when a purchase was intended, would be treated as operational losses.
The agencies generally propose to treat losses that are related to
both operational risk and credit risk as credit losses for purposes of
calculating risk-based capital requirements. For example, where a loan
defaults (credit risk) and the bank discovers that the collateral for
the loan was not properly secured (operational risk), the bank's
resulting loss would be attributed to credit risk (not operational
risk). This general separation between credit and operational risk is
supported by current U.S. accounting standards for the treatment of
credit risk.
The proposed exception to this standard is retail credit card fraud
losses. More specifically, retail credit card losses arising from non-
contractual, third party-initiated fraud (for example, identity theft)
are to be treated as external fraud operational losses under this
proposed rule. All other third party-initiated losses are to be treated
as credit losses. Based on discussions with the industry, this
distinction is consistent with prevailing practice in the credit card
industry, with banks commonly considering these losses to be
operational losses and treating them as such for risk management
purposes.
Question 27: The agencies seek commenters' perspectives on other
loss types for which the boundary between credit and operational risk
should be evaluated further (for example, with respect to losses on
HELOCs).
6. Boundary Between the Proposed Rule and the Market Risk Amendment
(MRA)
Positions currently subject to the MRA include all positions
classified as trading consistent with GAAP. The New Accord sets forth
additional criteria for positions to be eligible for application of the
MRA. The agencies propose to incorporate these additional criteria into
the MRA through a separate notice of proposed rulemaking concurrently
published in the Federal Register. Advanced approaches banks subject to
the MRA would use the MRA as amended for trading exposures eligible for
application of the MRA. Advanced approaches banks not subject to the
MRA would use this proposed rule for all of their exposures. Question
28: The agencies generally seek comment on the proposed treatment of
the boundaries between credit, operational, and market risk.
B. Risk-Weighted Assets for General Credit Risk (Wholesale Exposures,
Retail Exposures, On-Balance Sheet Assets That Are Not Defined by
Exposure Category, and Immaterial Credit Portfolios)
Under the proposed rule, the wholesale and retail risk-weighted
assets calculation consists of four phases: (1) Categorization of
exposures; (2) assignment of wholesale exposures to rating grades and
segmentation of retail exposures; (3) assignment of risk parameters to
wholesale obligors and exposures and segments of retail exposures; and
(4) calculation of risk-weighted asset amounts. Phase 1 involves the
categorization of a bank's exposures into four general categories--
wholesale exposures, retail exposures, securitization exposures, and
equity exposures. Phase 1 also involves the further classification of
retail exposures into subcategories and identifying certain wholesale
exposures that receive a specific treatment within the wholesale
framework. Phase 2 involves the assignment of wholesale obligors and
exposures to rating grades and the segmentation of retail exposures.
Phase 3 requires the bank to assign a PD, ELGD, LGD, EAD, and M to each
wholesale exposure and a PD, ELGD, LGD, and EAD to each segment of
retail exposures. In phase 4, the bank calculates the risk-weighted
asset amount (i) for each wholesale exposure and segment of retail
exposures by inserting the risk parameter estimates into the
appropriate IRB risk-based capital formula and multiplying the
formula's dollar risk-based capital requirement output by 12.5; and
(ii) for on-balance sheet assets that are not included in one of the
defined exposure categories and for certain immaterial portfolios of
exposures by multiplying the carrying value or notional amount of the
exposures by a 100 percent risk weight.
1. Phase 1--Categorization of Exposures
In phase 1, a bank must determine which of its exposures fall into
each of the four principal IRB exposure categories--wholesale
exposures, retail exposures, securitization exposures, and equity
exposures. In addition, a bank must identify within the wholesale
exposure category certain exposures that receive a special treatment
under the wholesale framework. These exposures include HVCRE exposures,
sovereign exposures, eligible purchased wholesale receivables, eligible
margin loans, repo-style transactions, OTC derivative contracts,
unsettled transactions, and eligible guarantees and eligible credit
derivatives that are used as credit risk mitigants.
The treatment of HVCRE exposures and eligible purchased wholesale
receivables is discussed below in this section. The treatment of
eligible margin loans, repo-style transactions, OTC derivative
contracts, and eligible guarantees and eligible credit derivatives that
are credit risk mitigants is discussed in section V.C. of the preamble.
In addition, sovereign exposures and exposures to or directly and
unconditionally guaranteed by the Bank for International Settlements,
the International Monetary Fund, the European Commission, the European
Central Bank, and multi-lateral development banks \46\ are exempt from
the 0.03 percent floor on PD discussed in the next section.
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\46\ Multi-lateral development bank is defined as any multi-
lateral lending institution or regional development bank in which
the U.S. government is a shareholder or contributing member. These
institutions currently are the International Bank for Reconstruction
and Development, the International Finance Corporation, the Inter-
American Development Bank, the Asian Development Bank, the African
Development Bank, and the European Bank for Reconstruction and
Development.
---------------------------------------------------------------------------
In phase 1, a bank also must subcategorize its retail exposures as
residential mortgage exposures, QREs, or other retail exposures. In
addition, a bank must identify any on-balance sheet asset that does not
meet the definition of a wholesale, retail, securitization, or equity
exposure, as well as any non-material portfolio of exposures to which
it chooses, subject to supervisory review, not to apply the IRB risk-
based capital formulas.
2. Phase 2 Assignment of Wholesale Obligors and Exposures to Rating
Grades and Retail Exposures to Segments
In phase 2, a bank must assign each wholesale obligor to a single
rating grade (for purposes of assigning an estimated PD) and may assign
each wholesale exposure to loss severity rating grades (for purposes of
assigning an estimated ELGD and LGD). A bank that elects not use a loss
severity rating grade system for a wholesale exposure will directly
assign ELGD and LGD to the wholesale exposure in phase 3. As a part of
the process of assigning wholesale obligors to rating grades, a bank
must identify which of its wholesale obligors are in default.
In addition, a bank must divide its retail exposures within each
retail subcategory into segments that have homogeneous risk
characteristics.\47\
[[Page 55862]]
Segmentation is the grouping of exposures within each subcategory
according to the predominant risk characteristics of the borrower (for
example, credit score, debt-to-income ratio, and delinquency) and the
exposure (for example, product type and LTV ratio). In general, retail
segments should not cross national jurisdictions. A bank would have
substantial flexibility to use the retail portfolio segmentation it
believes is most appropriate for its activities, subject to the
following broad principles:
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\47\ A bank must segment defaulted retail exposures separately
from non-defaulted retail exposures and, if the bank determines the
EAD for eligible margin loans using the approach in section 32(a) of
the proposed rule, it must segment retail eligible margin loans for
which the bank uses this approach separately from other retail
exposures.
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Differentiation of risk--Segmentation should provide
meaningful differentiation of risk. Accordingly, in developing its risk
segmentation system, a bank should consider the chosen risk drivers'
ability to separate risk consistently over time and the overall
robustness of the bank's approach to segmentation.
Reliable risk characteristics--Segmentation should use
borrower-related risk characteristics and exposure-related risk
characteristics that reliably and consistently over time differentiate
a segment's risk from that of other segments.
Consistency--Risk drivers for segmentation should be
consistent with the predominant risk characteristics used by the bank
for internal credit risk measurement and management.
Accuracy--The segmentation system should generate segments
that separate exposures by realized performance and should be designed
so that actual long-run outcomes closely approximate the retail risk
parameters estimated by the bank.
A bank might choose to segment exposures by common risk drivers
that are relevant and material in determining the loss characteristics
of a particular retail product. For example, a bank may segment
mortgage loans by LTV band, age from origination, geography,
origination channel, and credit score. Statistical modeling, expert
judgment, or some combination of the two may determine the most
relevant risk drivers. Alternatively, a bank might segment by grouping
exposures with similar loss characteristics, such as loss rates or
default rates, as determined by historical performance of segments with
similar risk characteristics.
Banks commonly obtain tranched credit protection, for example
first-loss or second-loss guarantees, on certain retail exposures such
as residential mortgages. The agencies recognize that the
securitization framework, which applies to tranched wholesale
exposures, is not appropriate for individual retail exposures. The
agencies therefore are proposing to exclude tranched guarantees that
apply only to an individual retail exposure from the securitization
framework. An important result of this exclusion is that, in contrast
to the treatment of wholesale exposures, a bank may recognize
recoveries from both an obligor and a guarantor for purposes of
estimating the ELGD and LGD for certain retail exposures. Question 29:
The agencies seek comment on this approach to tranched guarantees on
retail exposures and on alternative approaches that could more
appropriately reflect the risk mitigating effect of such guarantees
while addressing the agencies' concerns about counterparty credit risk
and correlation between the credit quality of an obligor and a
guarantor.
Banks have expressed concern about the treatment of retail margin
loans under the New Accord. Due to the highly collateralized nature and
low loss frequency of margin loans, banks typically collect little
customer-specific information that they could use to differentiate
margin loans into segments. The agencies believe that a bank could
appropriately segment its margin loan portfolio using only product-
specific risk drivers, such as product type and origination channel. A
bank could then use the retail definition of default to associate a PD,
ELGD, and LGD with each segment. As described in section 32 of the
proposed rule, a bank could adjust the EAD of eligible margin loans to
reflect the risk-mitigating effect of financial collateral. For a
segment of retail eligible margin loans, a bank would associate an ELGD
and LGD with the segment that do not reflect the presence of
collateral. If a bank is not able to estimate PD, ELGD, and LGD for a
segment of eligible margin loans, the bank may apply a 300 percent risk
weight to the EAD of the segment. Question 30: The agencies seek
comment on wholesale and retail exposure types for which banks are not
able to calculate PD, ELGD, and LGD and on what an appropriate risk-
based capital treatment for such exposures might be.
In phase 3, each retail segment will typically be associated with a
separate PD, ELGD, LGD, and EAD. In some cases, it may be reasonable to
use the same PD, ELGD, LGD, or EAD estimate for multiple segments.
A bank must segment defaulted retail exposures separately from non-
defaulted retail exposures and should base the segmentation of
defaulted retail exposures on characteristics that are most predictive
of current loss and recovery rates. This segmentation should provide
meaningful differentiation so that individual exposures within each
defaulted segment do not have material differences in their expected
loss severity.
Purchased wholesale receivables. A bank may also elect to use a
top-down approach, similar to the treatment of retail exposures, for
eligible purchased wholesale receivables. Under this approach, in phase
2, a bank would group its eligible purchased wholesale receivables
that, when consolidated by obligor, total less than $1 million into
segments that have homogeneous risk characteristics. To be an eligible
purchased wholesale receivable, several criteria must be met:
The purchased wholesale receivable must be purchased from
an unaffiliated seller and must not have been directly or indirectly
originated by the purchasing bank;
The purchased wholesale receivable must be generated on an
arm's-length basis between the seller and the obligor. Intercompany
accounts receivable and receivables subject to contra-accounts between
firms that buy and sell to each other are ineligible;
The purchasing bank must have a claim on all proceeds from
the receivable or a pro-rata interest in the proceeds; and
The purchased wholesale receivable must have an effective
remaining maturity of less than one year.
Wholesale lease residuals. The agencies are proposing a treatment
for wholesale lease residuals that differs from the New Accord. A
wholesale lease residual typically exposes a bank to the risk of a
decline in value of the leased asset and to the credit risk of the
lessee. Although the New Accord provides for a flat 100 percent risk
weight for wholesale lease residuals, the agencies believe this is
excessively punitive for leases to highly creditworthy lessees.
Accordingly, the proposed rule would require a bank to treat its net
investment in a wholesale lease as a single exposure to the lessee.
There would not be a separate capital calculation for the wholesale
lease residual. In contrast, a retail lease residual, consistent with
the New Accord, would be assigned a risk-weighted asset amount equal to
its residual value (as described in more detail above).
[[Page 55863]]
3. Phase 3--Assignment of Risk Parameters to Wholesale Obligors and
Exposures and Retail Segments
In phase 3, a bank would associate a PD with each wholesale obligor
rating grade; associate an ELGD or LGD with each wholesale loss
severity rating grade or assign an ELGD and LGD to each wholesale
exposure; assign an EAD and M to each wholesale exposure; and assign a
PD, ELGD, LGD, and EAD to each segment of retail exposures. The
quantification phase can generally be divided into four steps--
obtaining historical reference data, estimating the risk parameters for
the reference data, mapping the historical reference data to the bank's
current exposures, and determining the risk parameters for the bank's
current exposures.
A bank should base its estimation of the values assigned to PD,
ELGD, LGD, and EAD \48\ on historical reference data that are a
reasonable proxy for the bank's current exposures and that provide
meaningful predictions of the performance of such exposures. A
``reference data set'' consists of a set of exposures to defaulted
wholesale obligors and defaulted retail exposures (in the case of ELGD,
LGD, and EAD estimation) or to both defaulted and non-defaulted
wholesale obligors and retail exposures (in the case of PD estimation).
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\48\ EAD for repo-style transactions, eligible margin loans, and
OTC derivatives is calculated as described in section 32 of the
proposed rule.
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The reference data set should be described using a set of observed
characteristics. Relevant characteristics might include debt ratings,
financial measures, geographic regions, the economic environment and
industry/sector trends during the time period of the reference data,
borrower and loan characteristics related to the risk parameters (such
as loan terms, LTV ratio, credit score, income, debt-to-income ratio,
or performance history), or other factors that are related in some way
to the risk parameters. Banks may use more than one reference data set
to improve the robustness or accuracy of the parameter estimates.
A bank should then apply statistical techniques to the reference
data to determine a relationship between risk characteristics and the
estimated risk parameter. The result of this step is a model that ties
descriptive characteristics to the risk parameter estimates. In this
context, the term `model' is used in the most general sense; a model
may be simple, such as the calculation of averages, or more
complicated, such as an approach based on advanced regression
techniques. This step may include adjustments for differences between
this proposed rule's definition of default and the default definition
in the reference data set, or adjustments for data limitations. This
step should also include adjustments for seasoning effects related to
retail exposures.
A bank may use more than one estimation technique to generate
estimates of the risk parameters, especially if there are multiple sets
of reference data or multiple sample periods. If multiple estimates are
generated, the bank must have a clear and consistent policy on
reconciling and combining the different estimates.
Once a bank estimates PD, ELGD, LGD, and EAD for its reference data
sets, it would create a link between its portfolio data and the
reference data based on corresponding characteristics. Variables or
characteristics that are available for the existing portfolio would be
mapped or linked to the variables used in the default, loss-severity,
or exposure amount model. In order to effectively map the data,
reference data characteristics would need to allow for the construction
of rating and segmentation criteria that are consistent with those used
on the bank's portfolio. An important element of mapping is making
adjustments for differences between reference data sets and the bank's
exposures.
Finally, a bank would apply the risk parameters estimated for the
reference data to the bank's actual portfolio data. The bank would
attribute a PD to each wholesale obligor and each segment of retail
exposures, and an ELGD, LGD, and EAD to each wholesale exposure and to
each segment of retail exposures. If multiple data sets or estimation
methods are used, the bank must adopt a means of combining the various
estimates at this stage.
The proposed rule, as noted above, permits a bank to elect to
segment its eligible purchased wholesale receivables like retail
exposures. A bank that chooses to apply this treatment must directly
assign a PD, ELGD, LGD, EAD, and M to each such segment. If a bank can
estimate ECL (but not PD or LGD) for a segment of eligible purchased
wholesale receivables, the bank must assume that the ELGD and LGD of
the segment equal 100 percent and that the PD of the segment equals ECL
divided by EAD. The bank must estimate ECL for the receivables without
regard to any assumption of recourse or guarantees from the seller or
other parties. The bank would then use the wholesale exposure formula
in section 31(e) of the proposed rule to determine the risk-based
capital requirement for each segment of eligible purchased wholesale
receivables.
A bank may recognize the credit risk mitigation benefits of
collateral that secures a wholesale exposure by adjusting its estimate
of the ELGD and LGD of the exposure and may recognize the credit risk
mitigation benefits of collateral that secures retail exposures by
adjusting its estimate of the PD, ELGD, and LGD of the segment of
retail exposures. In certain cases, however, a bank may take financial
collateral into account in estimating the EAD of repo-style
transactions, eligible margin loans, and OTC derivative contracts (as
provided in section 32 of the proposed rule).
The proposed rule also provides that a bank may use an EAD of zero
for (i) derivative contracts that are traded on an exchange that
requires the daily receipt and payment of cash-variation margin; (ii)
derivative contracts and repo-style transactions that are outstanding
with a qualifying central counterparty, but not for those transactions
that the qualifying central counterparty has rejected; and (iii) credit
risk exposures to a qualifying central counterparty that arise from
derivative contracts and repo-style transactions in the form of
clearing deposits and posted collateral. The proposed rule defines a
qualifying central counterparty as a counterparty (for example, a
clearing house) that: (i) Facilitates trades between counterparties in
one or more financial markets by either guaranteeing trades or novating
contracts; (ii) requires all participants in its arrangements to be
fully collateralized on a daily basis; and (iii) the bank demonstrates
to the satisfaction of its primary Federal supervisor is in sound
financial condition and is subject to effective oversight by a national
supervisory authority.
Some repo-style transactions and OTC derivative contracts giving
rise to counterparty credit risk may give rise, from an accounting
point of view, to both on- and off-balance sheet exposures. Where a
bank is using an EAD approach to measure the amount of risk exposure
for such transactions, factoring in collateral effects where
applicable, it would not also separately apply a risk-based capital
requirement to an on-balance sheet receivable from the counterparty
recorded in connection with that transaction. Because any exposure
arising from the on-balance sheet receivable is captured in the capital
requirement determined under the EAD approach, a separate capital
requirement would double count the
[[Page 55864]]
exposure for regulatory capital purposes.
A bank may take into account the risk reducing effects of eligible
guarantees and eligible credit derivatives in support of a wholesale
exposure by applying the PD substitution approach or the LGD adjustment
approach to the exposure as provided in section 33 of the proposed rule
or, if applicable, applying double default treatment to the exposure as
provided in section 34 of the proposed rule. A bank may decide
separately for each wholesale exposure that qualifies for the double
default treatment whether to apply the PD substitution approach, the
LGD adjustment approach, or the double default treatment. A bank may
take into account the risk reducing effects of guarantees and credit
derivatives in support of retail exposures in a segment when
quantifying the PD, ELGD, and LGD of the segment.
There are several supervisory limitations imposed on risk
parameters assigned to wholesale obligors and exposures and segments of
retail exposures. First, the PD for each wholesale obligor or segment
of retail exposures may not be less than 0.03 percent, except for
exposures to or directly and unconditionally guaranteed by a sovereign
entity, the Bank for International Settlements, the International
Monetary Fund, the European Commission, the European Central Bank, or a
multi-lateral development bank, to which the bank assigns a rating
grade associated with a PD of less than 0.03 percent. Second, the LGD
of a segment of residential mortgage exposures (other than segments of
residential mortgage exposures for which all or substantially all of
the principal of the exposures is directly and unconditionally
guaranteed by the full faith and credit of a sovereign entity) may not
be less than 10 percent. These supervisory floors on PD and LGD apply
regardless of whether the bank recognizes an eligible guarantee or
eligible credit derivative as provided in sections 33 and 34 of the
proposed rule.
The agencies would not allow a bank to artificially group exposures
into segments specifically to avoid the LGD floor for mortgage
products. A bank should use consistent risk drivers to determine its
retail exposure segmentations and not artificially segment low LGD
loans with higher LGD loans to avoid the floor.
A bank also must calculate the effective remaining maturity (M) for
each wholesale exposure. For wholesale exposures other than repo-style
transactions, eligible margin loans, and OTC derivative contracts
subject to a qualifying master netting agreement, M would be the
weighted-average remaining maturity (measured in whole or fractional
years) of the expected contractual cash flows from the exposure, using
the undiscounted amounts of the cash flows as weights. A bank may use
its best estimate of future interest rates to compute expected
contractual interest payments on a floating-rate exposure, but it may
not consider expected but noncontractually required returns of
principal, when estimating M. A bank could, at its option, use the
nominal remaining maturity (measured in whole or fractional years) of
the exposure. The M for repo-style transactions, eligible margin loans,
and OTC derivative contracts subject to a qualifying master netting
agreement would be the weighted-average remaining maturity (measured in
whole or fractional years) of the individual transactions subject to
the qualifying master netting agreement, with the weight of each
individual transaction set equal to the notional amount of the
transaction. Question 31: The agencies seek comment on the
appropriateness of permitting a bank to consider prepayments when
estimating M and on the feasibility and advisability of using
discounted (rather than undiscounted) cash flows as the basis for
estimating M.
Under the proposed rule, a qualifying master netting agreement is
defined to mean any written, legally enforceable bilateral agreement,
provided that:
(i) The agreement creates a single legal obligation for all
individual transactions covered by the agreement upon an event of
default, including bankruptcy, insolvency, or similar proceeding, of
the counterparty;
(ii) The agreement provides the bank the right to accelerate,
terminate, and close-out on a net basis all transactions under the
agreement and to liquidate or set off collateral promptly upon an event
of default, including upon an event of bankruptcy, insolvency, or
similar proceeding, of the counterparty, provided that, in any such
case, any exercise of rights under the agreement will not be stayed or
avoided under applicable law in the relevant jurisdictions;
(iii) The bank has conducted and documented sufficient legal review
to conclude with a well-founded basis that the agreement meets the
requirements of paragraph (ii) of this definition and that in the event
of a legal challenge (including one resulting from default or from
bankruptcy, insolvency, or similar proceeding) the relevant court and
administrative authorities would find the agreement to be legal, valid,
binding, and enforceable under the law of the relevant jurisdictions;
(iv) The bank establishes and maintains procedures to monitor
possible changes in relevant law and to ensure that the agreement
continues to satisfy the requirements of this definition; and
(v) The agreement does not contain a walkaway clause (that is, a
provision that permits a non-defaulting counterparty to make lower
payments than it would make otherwise under the agreement, or no
payment at all, to a defaulter or the estate of a defaulter, even if
the defaulter or the estate of the defaulter is a net creditor under
the agreement).
The agencies would consider the following jurisdictions to be
relevant for a qualifying master netting agreement: The jurisdiction in
which each counterparty is chartered or the equivalent location in the
case of non-corporate entities, and if a branch of a counterparty is
involved, then also the jurisdiction in which the branch is located;
the jurisdiction that governs the individual transactions covered by
the agreement; and the jurisdiction that governs the agreement.
For most exposures, M may be no greater than five years and no less
than one year. For exposures that have an original maturity of less
than one year and are not part of a bank's ongoing financing of the
obligor, however, a bank may set M equal to the greater of one day and
M. An exposure is not part of a bank's ongoing financing of the obligor
if the bank (i) has a legal and practical ability not to renew or roll
over the exposure in the event of credit deterioration of the obligor;
(ii) makes an independent credit decision at the inception of the
exposure and at every renewal or rollover; and (iii) has no substantial
commercial incentive to continue its credit relationship with the
obligor in the event of credit deterioration of the obligor. Examples
of transactions that may qualify for the exemption from the one-year
maturity floor include due from other banks, including deposits in
other banks; bankers' acceptances; sovereign exposures; short-term
self-liquidating trade finance exposures; repo-style transactions;
eligible margin loans; unsettled trades and other exposures resulting
from payment and settlement processes; and collateralized OTC
derivative contracts subject to daily remargining.
4. Phase 4--Calculation of Risk-Weighted Assets
After a bank assigns risk parameters to each of its wholesale
obligors and
[[Page 55865]]
exposures and retail segments, the bank would calculate the dollar
risk-based capital requirement for each wholesale exposure to a non-
defaulted obligor or segment of non-defaulted retail exposures (except
eligible guarantees and eligible credit derivatives that hedge another
wholesale exposure and exposures to which the bank is applying the
double default treatment in section 34 of the proposed rule) by
inserting the risk parameters for the wholesale obligor and exposure or
retail segment into the appropriate IRB risk-based capital formula
specified in Table C and multiplying the output of the formula (K) by
the EAD of the exposure or segment. Eligible guarantees and eligible
credit derivatives that are hedges of a wholesale exposure would be
reflected in the risk-weighted assets amount of the hedged exposure (i)
through adjustments made to the risk parameters of the hedged exposure
under the PD substitution or LGD adjustment approach in section 33 of
the proposed rule or (ii) through a separate double default risk-based
capital requirement formula in section 34 of the proposed rule.
[GRAPHIC] [TIFF OMITTED] TP25SE06.077
The sum of the dollar risk-based capital requirements for wholesale
exposures to a non-defaulted obligor and segments of non-defaulted
retail exposures (including exposures subject to the double default
treatment described below) would equal the total dollar risk-based
capital requirement for those exposures and segments. The total dollar
risk-based capital requirement would be converted into a risk-weighted
asset amount by multiplying it by 12.5.
To compute the risk-weighted asset amount for a wholesale exposure
to a defaulted obligor, a bank would first have to compare two amounts:
(i) The sum of 0.08 multiplied by the EAD of the wholesale exposure
plus the amount of any charge-offs or write-downs on the exposure; and
(ii) K for the wholesale exposure (as determined in Table C immediately
before the obligor became defaulted), multiplied by the EAD of the
exposure immediately before the exposure became defaulted. If the
amount calculated in (i) is equal to or greater than the amount
calculated in (ii), the dollar risk-based capital requirement for the
exposure is 0.08 multiplied by the EAD of the exposure. If the amount
calculated in (i) is less than the amount calculated in (ii), the
[[Page 55866]]
dollar risk-based capital requirement for the exposure is K for the
exposure (as determined in Table C immediately before the obligor
became defaulted), multiplied by the EAD of the exposure. The reason
for this comparison is to ensure that a bank does not receive a
regulatory capital benefit as a result of the exposure moving from non-
defaulted to defaulted status.
The proposed rule provides a simpler approach for segments of
defaulted retail exposures. The dollar risk-based capital requirement
for a segment of defaulted retail exposures equals 0.08 multiplied by
the EAD of the segment. The agencies are proposing this uniform 8
percent risk-based capital requirement for defaulted retail exposures
to ease implementation burden on banks and in light of accounting and
other supervisory policies in the retail context that would help
prevent the sum of a bank's ECL and risk-based capital requirement for
a retail exposure from declining at the time of default.
To convert the dollar risk-based capital requirements to a risk-
weighted asset amount, the bank would sum the dollar risk-based capital
requirements for all wholesale exposures to defaulted obligors and
segments of defaulted retail exposures and multiply the sum by 12.5.
A bank could assign a risk-weighted asset amount of zero to cash
owned and held in all offices of the bank or in transit, and for gold
bullion held in the bank's own vaults or held in another bank's vaults
on an allocated basis, to the extent it is offset by gold bullion
liabilities. On-balance-sheet assets that do not meet the definition of
a wholesale, retail, securitization, or equity exposure--for example,
property, plant, and equipment and mortgage servicing rights--and
portfolios of exposures that the bank has demonstrated to its primary
Federal supervisor's satisfaction are, when combined with all other
portfolios of exposures that the bank seeks to treat as immaterial for
risk-based capital purposes, not material to the bank generally would
be assigned risk-weighted asset amounts equal to their carrying value
(for on-balance-sheet exposures) or notional amount (for off-balance-
sheet exposures). For this purpose, the notional amount of an OTC
derivative contract that is not a credit derivative is the EAD of the
derivative as calculated in section 32 of the proposed rule.
Total wholesale and retail risk-weighted assets would be the sum of
risk-weighted assets for wholesale exposures to non-defaulted obligors
and segments of non-defaulted retail exposures, wholesale exposures to
defaulted obligors and segments of defaulted retail exposures, assets
not included in an exposure category, non-material portfolios of
exposures, and unsettled transactions minus the amounts deducted from
capital pursuant to the general risk-based capital rules (excluding
those deductions reversed in section 12 of the proposed rule).
5. Statutory Provisions on the Regulatory Capital Treatment of Certain
Mortgage Loans
The general risk-based capital rules assign 50 and 100 percent risk
weights to certain one- to four-family residential pre-sold
construction loans and multifamily residential loans.\49\ The agencies
adopted these provisions as a result of the Resolution Trust
Corporation Refinancing, Restructuring, and Improvement Act of 1991
(RTCRRI Act).\50\ The RTCRRI Act mandates that each agency provide in
its capital regulations (i) a 50 percent risk weight for certain one-
to four-family residential pre-sold construction loans and multifamily
residential loans that meet specific statutory criteria set forth in
the Act and any other underwriting criteria imposed by the agencies;
and (ii) a 100 percent risk weight for one- to four-family residential
pre-sold construction loans for residences for which the purchase
contract is cancelled.\51\
---------------------------------------------------------------------------
\49\ See 12 CFR part 3, Appendix A, section 3(a)(3)(iii)
(national banks); 12 CFR part 208, Appendix A, section III.C.3.
(state member banks); 12 CFR part 225, Appendix A, section III.C.3.
(bank holding companies); 12 CFR part 325, Appendix A, section
II.C.a. (state nonmember banks); 12 CFR 567.6(a)(1)(iii) and (iv)
(savings associations).
\50\ See sections 618(a) and (b) of the RTCRRI Act. The first
class includes loans for the construction of a residence consisting
of 1- to 4-family dwelling units that have been pre-sold under firm
contracts to purchasers who have obtained firm commitments for
permanent qualifying mortgages and have made substantial earnest
money deposits. The second class includes loans that are secured by
a first lien on a residence consisting of more than 4 dwelling units
if the loan meets certain criteria outlined in the RTCRRI Act.
\51\ See sections 618(a) and (b) of the RTCRRI Act.
---------------------------------------------------------------------------
When Congress enacted the RTCRRI Act in 1991, the agencies' risk-
based capital rules reflected the Basel I framework. Consequently, the
risk weight treatment for certain categories of mortgage loans in the
RTCRRI Act assumes a risk weight bucketing approach, instead of the
more risk-sensitive IRB approach in the Basel II framework.
For purposes of this proposed rule implementing the Basel II IRB
approach, the agencies are proposing that the three types of
residential mortgage loans addressed by the RTCRRI Act should continue
to receive the risk weights provided in the Act. Specifically,
consistent with the general risk-based capital rules, the proposed rule
requires a bank to use the following risk weights (instead of the risk
weights that would otherwise be produced under the IRB risk-based
capital formulas): (i) A 50 percent risk weight for one- to four-family
residential construction loans if the residences have been pre-sold
under firm contracts to purchasers who have obtained firm commitments
for permanent qualifying mortgages and have made substantial earnest
money deposits, and the loans meet the other underwriting
characteristics established by the agencies in the general risk-based
capital rules; \52\ (ii) a 50 percent risk weight for multifamily
residential loans that meet certain statutory loan-to-value, debt-to-
income, amortization, and performance requirements, and meet the other
underwriting characteristics established by the agencies in the general
risk-based capital rules; \53\ and (iii) a 100 percent risk weight for
one- to four-family residential pre-sold construction loans for a
residence for which the purchase contract is canceled.\54\ Mortgage
loans that do not meet the relevant criteria do not qualify for the
statutory risk weights and will be risk-weighted according to the IRB
risk-based capital formulas.
---------------------------------------------------------------------------
\52\ See section 618(a)(1)((B) of the RTCRRI Act.
\53\ See section 618(b)(1)(B) of the RTCRRI Act.
\54\ See section 618(a)(2) of the RTCRRI Act.
---------------------------------------------------------------------------
The agencies understand that there is a tension between the
statutory risk weights provided by the RTCRRI Act and the more risk-
sensitive IRB approaches to risk-based capital that are contained in
this proposed rule. Question 32: The agencies seek comment on whether
the agencies should impose the following underwriting criteria as
additional requirements for a Basel II bank to qualify for the
statutory 50 percent risk weight for a particular mortgage loan: (i)
That the bank has an IRB risk measurement and management system in
place that assesses the PD and LGD of prospective residential mortgage
exposures; and (ii) that the bank's IRB system generates a 50 percent
risk weight for the loan under the IRB risk-based capital formulas. The
agencies note that a capital-related provision of the Federal Deposit
Insurance Corporation Improvement Act of 1991 (FDICIA), enacted by
Congress just four days after its adoption of the RTCRRI Act, directs
each agency to revise its risk-based capital standards for DIs to
ensure that those standards ``reflect the
[[Page 55867]]
actual performance and expected risk of loss of multifamily
mortgages.'' \55\
---------------------------------------------------------------------------
\55\ Section 305(b)(1)(B) of FDICIA (12 U.S.C. 1828 notes).
---------------------------------------------------------------------------
Question 33: The agencies seek comment on all aspects of the
proposed treatment of one- to four-family residential pre-sold
construction loans and multifamily residential loans.
C. Credit Risk Mitigation (CRM) Techniques
Banks use a number of techniques to mitigate credit risk. This
section of the preamble describes how the proposed rule recognizes the
risk-mitigating effects of both financial collateral (defined below)
and nonfinancial collateral, as well as guarantees and credit
derivatives, for risk-based capital purposes. To recognize credit risk
mitigants for risk-based capital purposes, a bank should have in place
operational procedures and risk management processes that ensure that
all documentation used in collateralizing or guaranteeing a transaction
is legal, valid, binding, and enforceable under applicable law in the
relevant jurisdictions. The bank should have conducted sufficient legal
review to reach a well-founded conclusion that the documentation meets
this standard and should reconduct such a review as necessary to ensure
continuing enforceability.
Although the use of CRM techniques may reduce or transfer credit
risk, it simultaneously may increase other risks, including
operational, liquidity, and market risks. Accordingly, it is imperative
that banks employ robust procedures and processes to control risks,
including roll-off risk and concentration risk, arising from the bank's
use of CRM techniques and to monitor the implications of using CRM
techniques for the bank's overall credit risk profile.
1. Collateral
Under the proposed rule, a bank generally recognizes collateral
that secures a wholesale exposure as part of the ELGD and LGD
estimation process and generally recognizes collateral that secures a
retail exposure as part of the PD, ELGD, and LGD estimation process, as
described above in section V.B.3. of the preamble. However, in certain
limited circumstances described in the next section, a bank may adjust
EAD to reflect the risk mitigating effect of financial collateral.
When reflecting the credit risk mitigation benefits of collateral
in its estimation of the risk parameters of a wholesale or retail
exposure, a bank should:
(i) Conduct sufficient legal review to ensure, at inception and on
an ongoing basis, that all documentation used in the collateralized
transaction is binding on all parties and legally enforceable in all
relevant jurisdictions;
(ii) Consider the relation (that is, correlation) between obligor
risk and collateral risk in the transaction;
(iii) Consider any currency and/or maturity mismatch between the
hedged exposure and the collateral;
(iv) Ground its risk parameter estimates for the transaction in
historical data, using historical recovery rates where available; and
(v) Fully take into account the time and cost needed to realize the
liquidation proceeds and the potential for a decline in collateral
value over this time period.
The bank also should ensure that:
(i) The legal mechanism under which the collateral is pledged or
transferred ensures that the bank has the right to liquidate or take
legal possession of the collateral in a timely manner in the event of
the default, insolvency, or bankruptcy (or other defined credit event)
of the obligor and, where applicable, the custodian holding the
collateral;
(ii) The bank has taken all steps necessary to fulfill legal
requirements to secure its interest in the collateral so that it has
and maintains an enforceable security interest;
(iii) The bank has clear and robust procedures for the timely
liquidation of collateral to ensure observation of any legal conditions
required for declaring the default of the borrower and prompt
liquidation of the collateral in the event of default;
(iv) The bank has established procedures and practices for (A)
conservatively estimating, on a regular ongoing basis, the market value
of the collateral, taking into account factors that could affect that
value (for example, the liquidity of the market for the collateral and
obsolescence or deterioration of the collateral), and (B) where
applicable, periodically verifying the collateral (for example, through
physical inspection of collateral such as inventory and equipment); and
(v) The bank has in place systems for promptly requesting and
receiving additional collateral for transactions whose terms require
maintenance of collateral values at specified thresholds.
2. EAD for Counterparty Credit Risk
This section describes two EAD-based methodologies--a collateral
haircut approach and an internal models methodology--that a bank may
use instead of an ELGD/LGD estimation methodology to recognize the
benefits of financial collateral in mitigating the counterparty credit
risk associated with repo-style transactions, eligible margin loans,
collateralized OTC derivative contracts, and single product groups of
such transactions with a single counterparty subject to a qualifying
master netting agreement. A third methodology, the simple VaR
methodology, is also available to recognize financial collateral
mitigating the counterparty credit risk of single product netting sets
of repo-style transactions and eligible margin loans.
A bank may use any combination of the three methodologies for
collateral recognition; however, it must use the same methodology for
similar exposures. A bank may choose to use one methodology for agency
securities lending transactions--that is, repo-style transactions in
which the bank, acting as agent for a customer, lends the customer's
securities and indemnifies the customer against loss--and another
methodology for all other repo-style transactions. This section also
describes the methodology for calculating EAD for an OTC derivative
contract or set of OTC derivative contracts subject to a qualifying
master netting agreement. Table D illustrates which EAD estimation
methodologies may be applied to particular types of exposure.
[[Page 55868]]
Table D
----------------------------------------------------------------------------------------------------------------
Models approach
Current Collateral ---------------------------
exposure haircut Simple VaR Internal
methodology approach \56\ models
methodology methodology
----------------------------------------------------------------------------------------------------------------
OTC derivative.......................................... X ............ ............ X
Recognition of collateral for OTC derivatives........... ............ X \57\ ............ X
Repo-style transaction.................................. ............ X X X
Eligible margin loan.................................... ............ X X X
Cross-product netting set............................... ............ ............ ............ X
----------------------------------------------------------------------------------------------------------------
Question 34: For purposes of determining EAD for counterparty
credit risk and recognizing collateral mitigating that risk, the
proposed rule allows banks to take into account only financial
collateral, which, by definition, does not include debt securities that
have an external rating lower than one rating category below investment
grade. The agencies invite comment on the extent to which lower-rated
debt securities or other securities that do not meet the definition of
financial collateral are used in these transactions and on the CRM
value of such securities.
---------------------------------------------------------------------------
\56\ Only repo-style transactions and eligible margin loans
subject to a single-product qualifying master netting agreement are
eligible for the simple VaR methodology.
\57\ In conjunction with the current exposure methodology.
---------------------------------------------------------------------------
EAD for repo-style transactions and eligible margin loans. Under
the proposal, a bank could recognize the risk mitigating effect of
financial collateral that secures a repo-style transaction, eligible
margin loan, or single-product group of such transactions with a single
counterparty subject to a qualifying master netting agreement (netting
set) through an adjustment to EAD rather than ELGD and LGD. The bank
may use a collateral haircut approach or one of two models approaches:
a simple VaR methodology (for single-product netting sets of repo-style
transactions or eligible margin loans) or an internal models
methodology. Figure 2 illustrates the methodologies available for
calculating EAD and LGD for eligible margin loans and repo-style
transactions.
The proposed rule defines repo-style transaction as a repurchase or
reverse repurchase transaction, or a securities borrowing or securities
lending transaction (including a transaction in which the bank acts as
agent for a customer and indemnifies the customer against loss),
provided that:
(i) The transaction is based solely on liquid and readily
marketable securities or cash;
(ii) The transaction is marked to market daily and subject to daily
margin maintenance requirements;
(iii) The transaction is executed under an agreement that provides
the bank the right to accelerate, terminate, and close-out the
transaction on a net basis and to liquidate or set off collateral
promptly upon an event of default (including upon an event of
bankruptcy, insolvency, or similar proceeding) of the counterparty,
provided that, in any such case, any exercise of rights under the
agreement will not be stayed or avoided under applicable law in the
relevant jurisdictions; \58\ and
---------------------------------------------------------------------------
\58\ This requirement is met where all transactions under the
agreement are (i) executed under U.S. law and (ii) constitute
``securities contracts'' or ``repurchase agreements'' under section
555 or 559, respectively, of the Bankruptcy Code (11 U.S.C. 555 or
559), qualified financial contracts under section 11(e)(8) of the
Federal Deposit Insurance Act (12 U.S.C. 1821(e)(8)), or netting
contracts between or among financial institutions under sections
401-407 of the Federal Deposit Insurance Corporation Improvement Act
of 1991 (12 U.S.C. 4401-4407) or the Federal Reserve Board's
Regulation EE (12 CFR part 231).
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[[Page 55869]]
[GRAPHIC] [TIFF OMITTED] TP25SE06.078
(iv) The bank has conducted and documented sufficient legal review
to conclude with a well-founded basis that the agreement meets the
requirements of paragraph (iii) of this definition and is legal, valid,
binding, and enforceable under applicable law in the relevant
jurisdictions.
Question 35: The agencies recognize that criterion (iii) above may
pose challenges for certain transactions that would not be eligible for
certain exemptions from bankruptcy or receivership laws because the
counterparty--for example, a sovereign entity or a pension fund--is not
subject to such laws. The agencies seek comment on ways this criterion
could be crafted to accommodate such transactions when justified on
prudential grounds, while ensuring that the requirements in criterion
(iii) are met for transactions that are eligible for those exemptions.
The proposed rule defines an eligible margin loan as an extension
of credit where:
(i) The credit extension is collateralized exclusively by debt or
equity securities that are liquid and readily marketable;
(ii) The collateral is marked to market daily and the transaction
is subject to daily margin maintenance requirements;
(iii) The extension of credit is conducted under an agreement that
provides the bank the right to accelerate and terminate the extension
of credit and to liquidate or set off collateral promptly upon an event
of default (including upon an event of bankruptcy, insolvency, or
similar proceeding) of the counterparty, provided that, in any such
case, any exercise of rights under the agreement will not be stayed or
avoided under applicable law in the relevant jurisdictions;\59\ and
---------------------------------------------------------------------------
\59\ This requirement is met under the circumstances described
in the previous footnote.
---------------------------------------------------------------------------
(iv) The bank has conducted and documented sufficient legal review
to conclude with a well-founded basis that the agreement meets the
requirements of paragraph (iii) of this definition and is legal, valid,
binding, and enforceable under applicable law in the relevant
jurisdictions.
The proposed rule describes various ways that a bank may recognize
the risk mitigating impact of financial collateral. The proposed rule
defines financial collateral as collateral in the form of any of the
following instruments in which the bank has a perfected, first priority
security interest or the legal equivalent thereof: (i) Cash on deposit
with the bank (including cash held for the bank by a third-party
custodian or trustee); (ii) gold bullion; (iii) long-term debt
securities that have an applicable external rating of one category
below investment grade or higher (for example, at least BB-); (iv)
short-term debt instruments that have an applicable external rating of
at least investment grade (for example, at least A-3); (v) equity
securities that are publicly traded; (vi) convertible bonds that are
publicly traded; and (vii) mutual fund shares for which a share price
is publicly quoted daily and money market mutual fund shares. Question
36: The agencies seek comment on the appropriateness of requiring that
a bank have a perfected, first priority security interest, or the legal
equivalent thereof, in the definition of financial collateral.
The proposed rule defines an external rating as a credit rating
assigned by a nationally recognized statistical rating organization
(NRSRO) to an exposure that fully reflects the entire amount of credit
risk the holder of the exposure has with regard to all payments owed to
it under the exposure. For example, if a holder is owed principal and
interest on an exposure, the external rating must
[[Page 55870]]
fully reflect the credit risk associated with timely repayment of
principal and interest. Moreover, the external rating must be published
in an accessible form and must be included in the transition matrices
made publicly available by the NRSRO that summarize the historical
performance of positions it has rated.\60\ Under the proposed rule, an
exposure's applicable external rating is the lowest external rating
assigned to the exposure by any NRSRO.
---------------------------------------------------------------------------
\60\ Banks should take particular care with these requirements
where the financial collateral is in the form of a securitization
exposure.
---------------------------------------------------------------------------
Collateral haircut approach. Under the collateral haircut approach,
a bank would set EAD equal to the sum of three quantities: (i) The
value of the exposure less the value of the collateral; (ii) the
absolute value of the net position in a given security (where the net
position in a given security equals the sum of the current market
values of the particular security the bank has lent, sold subject to
repurchase, or posted as collateral to the counterparty minus the sum
of the current market values of that same security the bank has
borrowed, purchased subject to resale, or taken as collateral from the
counterparty) multiplied by the market price volatility haircut
appropriate to that security; and (iii) the sum of the absolute values
of the net position of both cash and securities in each currency that
is different from the settlement currency multiplied by the haircut
appropriate to each currency mismatch. To determine the appropriate
haircuts, a bank could choose to use standard supervisory haircuts or
its own estimates of haircuts. For purposes of the collateral haircut
approach, a given security would include, for example, all securities
with a single Committee on Uniform Securities Identification Procedures
(CUSIP) number and would not include securities with different CUSIP
numbers, even if issued by the same issuer with the same maturity date.
Question 37: The agencies recognize that this is a conservative
approach and seek comment on other approaches to consider in
determining a given security for purposes of the collateral haircut
approach.
Standard Supervisory Haircuts
If a bank chooses to use standard supervisory haircuts, it would
use an 8 percent haircut for each currency mismatch and the haircut
appropriate to each security in table E below. These haircuts are based
on the 10-business-day holding period for eligible margin loans and may
be multiplied by the square root of \1/2\ to convert the standard
supervisory haircuts to the 5-business-day minimum holding period for
repo-style transactions. A bank must adjust the standard supervisory
haircuts upward on the basis of a holding period longer than 10
business days for eligible margin loans or 5 business days for repo-
style transactions where and as appropriate to take into account the
illiquidity of an instrument.
Table E.--Standard Supervisory Market Price Volatility Haircuts
----------------------------------------------------------------------------------------------------------------
Issuers exempt
Applicable external rating grade Residual maturity for debt securities from the 3 b.p. Other issuers
category for debt securities floor
----------------------------------------------------------------------------------------------------------------
Two highest investment grade rating <=1 year............................... .005 .01
categories for long-term ratings/ >1 year, <=5 years..................... .02 .04
highest investment grade rating >5 years............................... .04 .08
category for short-term ratings.
----------------------------------------------------------------------------------------------------------------
Two lowest investment grade rating <=1 year............................... .01 .02
categories for both short- and >1 year, <=5 years..................... .03 .06
long-term ratings. >5 years............................... .06 .12
----------------------------------------------------------------------------------------------------------------
One rating category below All.................................... .15 .25
investment grade.
----------------------------------------------------------------------------------------------------------------
Main index equities \61\ (including .15
convertible bonds) and gold.
----------------------------------------------------------------------------------------------------------------
Other publicly traded equities (including convertible bonds).....25.........
----------------------------------------------------------------------------------------------------------------
Mutual funds..........................Highest haircut applicable to any security in which the
fund can invest.
----------------------------------------------------------------------------------------------------------------
Cash on deposit with the bank (including a certificate of deposit0issued by
the bank).
----------------------------------------------------------------------------------------------------------------
As an example, assume a bank that uses standard supervisory
haircuts has extended an eligible margin loan of $100 that is
collateralized by 5-year U.S. Treasury notes with a market value of
$100. The value of the exposure less the value of the collateral would
be zero, and the net position in the security ($100) times the
supervisory haircut (.02) would be $2. There is no currency mismatch.
Therefore, the EAD of the exposure would be $0 + $2 = $2.
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\61\ The proposed rule defines a ``main index'' as the S&P 500
Index, the FTSE All-World Index, and any other index for which the
bank demonstrates to the satisfaction of its primary Federal
supervisor that the equities represented in the index have
comparable liquidity, depth of market, and size of bid-ask spreads
as equities in the S&P 500 Index and the FTSE All-World Index.
---------------------------------------------------------------------------
Own estimates of haircuts. With the prior written approval of the
bank's primary Federal supervisor, a bank may calculate security type
and currency mismatch haircuts using its own internal estimates of
market price volatility and foreign exchange volatility. The bank's
primary Federal supervisor would base approval to use internally
estimated haircuts on the satisfaction of certain minimum qualitative
and quantitative standards. These standards include: (i) The bank must
use a 99th percentile one-tailed confidence interval and a minimum 5-
business-day holding period for repo-style transactions and a minimum
10-business-day holding period for all other transactions; (ii) the
bank must adjust holding periods upward where and as appropriate to
take into account the illiquidity of an instrument; (iii) the bank must
select a historical observation period for calculating haircuts of at
least one year; and (iv) the bank must update its data sets and
recompute haircuts no less frequently than quarterly and must update
its data sets and recompute haircuts whenever market prices change
materially. A bank must estimate
[[Page 55871]]
individually the volatilities of the exposure, the collateral, and
foreign exchange rates, and may not take into account the correlations
between them.
A bank that uses internally estimated haircuts would have to adhere
to the following rules. The bank may calculate internally estimated
haircuts for categories of debt securities that have an applicable
external rating of at least investment grade. The haircut for a
category of securities would have to be representative of the internal
volatility estimates for securities in that category that the bank has
actually lent, sold subject to repurchase, posted as collateral,
borrowed, purchased subject to resale, or taken as collateral. In
determining relevant categories, the bank would have to take into
account (i) the type of issuer of the security; (ii) the applicable
external rating of the security; (iii) the maturity of the security;
and (iv) the interest rate sensitivity of the security. A bank would
calculate a separate internally estimated haircut for each individual
debt security that has an applicable external rating below investment
grade and for each individual equity security. In addition, a bank
would internally estimate a separate currency mismatch haircut for each
individual mismatch between each net position in a currency that is
different from the settlement currency.
When a bank calculates an internally estimated haircut on a
TN-day holding period, which is different from the minimum
holding period for the transaction type, the applicable haircut
(HM) must be calculated using the following square root of
time formula:
[GRAPHIC] [TIFF OMITTED] TP25SE06.039
Where:
(i) TM = 5 for repo-style transactions and 10 for
eligible margin loans;
(ii) TN = holding period used by the bank to derive
HN; and
(iii) HN = haircut based on the holding period
TN.
Simple VaR methodology. As noted above, a bank may use one of two
internal models approaches to recognize the risk mitigating effects of
financial collateral that secures a repo-style transaction or eligible
margin loan. This section of the preamble describes the simple VaR
methodology; a later section of the preamble describes the internal
models methodology (which also may be used to determine the EAD for OTC
derivative contracts).
With the prior written approval of its primary Federal supervisor,
a bank may estimate EAD for repo-style transactions and eligible margin
loans subject to a single product qualifying master netting agreement
using a VaR model. Under the simple VaR methodology, a bank's EAD for
the transactions subject to such a netting agreement would be equal to
the value of the exposures minus the value of the collateral plus a
VaR-based estimate of the potential future exposure (PFE), that is, the
maximum exposure expected to occur on a future date with a high level
of confidence. The value of the exposures is the sum of the current
market values of all securities and cash the bank has lent, sold
subject to repurchase, or posted as collateral to a counterparty under
the netting set. The value of the collateral is the sum of the current
market values of all securities and cash the bank has borrowed,
purchased subject to resale, or taken as collateral from a counterparty
under the netting set.
The VaR model must estimate the bank's 99th percentile, one-tailed
confidence interval for an increase in the value of the exposures minus
the value of the collateral ([Sigma]E - [Sigma]C) over a 5-business-day
holding period for repo-style transactions or over a 10-business-day
holding period for eligible margin loans using a minimum one-year
historical observation period of price data representing the
instruments that the bank has lent, sold subject to repurchase, posted
as collateral, borrowed, purchased subject to resale, or taken as
collateral.
The qualifying requirements for the use of a VaR model are less
stringent than the qualification requirements for the internal models
methodology described below. The main ongoing qualification requirement
for using a VaR model is that the bank must validate its VaR model by
establishing and maintaining a rigorous and regular backtesting regime.
3. EAD for OTC Derivative Contracts
A bank may use either the current exposure methodology or the
internal models methodology to determine the EAD for OTC derivative
contracts. An OTC derivative contract is defined as a derivative
contract that is not traded on an exchange that requires the daily
receipt and payment of cash-variation margin. A derivative contract is
defined to include interest rate derivative contracts, exchange rate
derivative contracts, equity derivative contracts, commodity derivative
contracts, credit derivatives, and any other instrument that poses
similar counterparty credit risks. The proposed rule also would define
derivative contracts to include unsettled securities, commodities, and
foreign exchange trades with a contractual settlement or delivery lag
that is longer than the normal settlement period (which the proposed
rule defines as the lesser of the market standard for the particular
instrument or 5 business days). This would include, for example, agency
mortgage-backed securities transactions conducted in the To-Be-
Announced market.
Figure 3 illustrates the treatment of OTC derivative contracts.
[[Page 55872]]
[GRAPHIC] [TIFF OMITTED] TP25SE06.079
Current exposure methodology. The proposed current exposure
methodology for determining EAD for single OTC derivative contracts is
similar to the methodology in the general risk-based capital rules, in
that the EAD for an OTC derivative contract would be equal to the sum
of the bank's current credit exposure and PFE on the derivative
contract. The current credit exposure for a single OTC derivative
contract is the greater of the mark-to-market value of the derivative
contract or zero.
The proposed current exposure methodology for OTC derivative
contracts subject to qualifying master netting agreements is also
similar to the treatment set forth in the agencies' general risk-based
capital rules. Banks would need to calculate net current exposure and
adjust the gross PFE using a formula that includes the net to gross
current exposure ratio. Moreover, under the agencies' general risk-
based capital rules, a bank may not recognize netting agreements for
OTC derivative contracts for capital purposes unless it obtains a
written and reasoned legal opinion representing that, in the event of a
legal challenge, the bank's exposure would be found to be the net
amount in the relevant jurisdictions. The agencies are proposing to
retain this standard for netting agreements covering OTC derivative
contracts. While the legal enforceability of contracts is necessary for
a bank to recognize netting effects in the capital calculation, there
may be ways other than obtaining an explicit written opinion to ensure
the enforceability of a contract. For example, the use of industry
developed standardized contracts for certain OTC products and reliance
on commissioned legal opinions as to the enforceability of these
contracts in many jurisdictions may be sufficient. Question 38: The
agencies seek comment on methods banks would use to ensure
enforceability of single product OTC derivative netting agreements in
the absence of an explicit written legal opinion requirement.
The proposed rule's conversion factor (CF) matrix used to compute
PFE is based on the matrices in the general risk-based capital rules,
with two exceptions. First, under the proposed rule the CF for credit
derivatives that are not used to hedge the credit risk of exposures
subject to an IRB credit risk capital requirement is specified to be
5.0 percent for contracts with investment grade reference obligors and
10.0 percent for contracts with non-investment grade obligors.\62\ The
CF for a credit derivative contract does not depend on the remaining
maturity of the contract. The second change is that floating/floating
basis swaps would no longer be exempted from the CF for interest rate
derivative contracts. The exemption was put into place when such swaps
were very simple, and the
[[Page 55873]]
agencies believe it is no longer appropriate given the evolution of the
product. The computation of the PFE of multiple OTC derivative
contracts subject to a qualifying master netting agreement would not
change from the general risk-based capital rules.
---------------------------------------------------------------------------
\62\ The counterparty credit risk of a credit derivative that is
used to hedge the credit risk of an exposure subject to an IRB
credit risk capital requirement is captured in the IRB treatment of
the hedged exposure, as detailed in sections 33 and 34 of the
proposed rule.
---------------------------------------------------------------------------
If an OTC derivative contract is collateralized by financial
collateral, a bank would first determine an unsecured EAD as described
above and in section 32(b) of the proposed rule. To take into account
the risk-reducing effects of the financial collateral, the bank may
either adjust the ELGD and LGD of the contract or, if the transaction
is subject to daily marking-to-market and remargining, adjust the EAD
of the contract using the collateral haircut approach for repo-style
transactions and eligible margin loans described above and in section
32(a) of the proposed rule.
Under part VI of the proposed rule, a bank must treat an equity
derivative contract as an equity exposure and compute a risk-weighted
asset amount for that exposure. If the bank is using the internal
models approach for its equity exposures, it also must compute a risk-
weighted asset amount for its counterparty credit risk exposure on the
equity derivative contract. However, if the bank is using the simple
risk weight approach for its equity exposures, it may choose not to
hold risk-based capital against the counterparty credit risk of the
equity derivative contract. Likewise, a bank that purchases a credit
derivative that is recognized under section 33 or 34 of the proposed
rule as a credit risk mitigant for an exposure that is not a covered
position under the MRA does not have to compute a separate counterparty
credit risk capital requirement for the credit derivative. If a bank
chooses not to hold risk-based capital against the counterparty credit
risk of such equity or credit derivative contracts, it must do so
consistently for all such equity derivative contracts or for all such
credit derivative contracts. Further, where the contracts are subject
to a qualifying master netting agreement, the bank must either include
them all or exclude them all from any measure used to determine
counterparty credit risk exposure to all relevant counterparties for
risk-based capital purposes.
Where a bank provides protection through a credit derivative that
is not treated as a covered position under the MRA, it must treat the
credit derivative as a wholesale exposure to the reference obligor and
compute a risk-weighted asset amount for the credit derivative under
section 31 of the proposed rule. The bank need not compute a
counterparty credit risk capital requirement for the credit derivative,
so long as it does so consistently for all such credit derivatives and
either includes all or excludes all such credit derivatives that are
subject to a master netting contract from any measure used to determine
counterparty credit risk exposure to all relevant counterparties for
risk-based capital purposes. Where the bank provides protection through
a credit derivative treated as a covered position under the MRA, it
must compute a counterparty credit risk capital requirement under
section 32 of the proposed rule.
4. Internal Models Methodology
This proposed rule includes an internal models methodology for the
calculation of EAD for transactions with counterparty credit exposure,
namely, OTC derivatives, eligible margin loans, and repo-style
transactions. The internal models methodology requires a risk model
that captures counterparty credit risk and estimates EAD at the level
of a ``netting set.'' A netting set is a group of transactions with a
single counterparty that are subject to a qualifying master netting
agreement. A transaction not subject to a qualifying master netting
agreement is considered to be its own netting set and EAD must be
calculated for each such transaction individually. A bank may use the
internal models methodology for OTC derivatives (collateralized or
uncollateralized) and single-product netting sets thereof, for eligible
margin loans and single-product netting sets thereof, or for repo-style
transactions and single-product netting sets thereof. A bank that uses
the internal models methodology for a particular transaction type (that
is, OTC derivative contracts, eligible margin loans, or repo-style
transactions) must use the internal models methodology for all
transactions in that transaction type. However, a bank may choose
whether or not to use the internal models methodology for each
transaction type.
A bank also may use the internal models methodology for OTC
derivatives, eligible margin loans, and repo-style transactions subject
to a qualifying cross-product master netting agreement if (i) the bank
effectively integrates the risk mitigating effects of cross-product
netting into its risk management and other information technology
systems; and (ii) the bank obtains the prior written approval of its
primary Federal supervisor.
A qualifying cross-product master netting agreement is defined as a
qualifying master netting agreement that provides for termination and
close-out netting across multiple types of financial transactions or
qualifying master netting agreements in the event of a counterparty's
default, provided that:
(i) The underlying financial transactions are OTC derivative
contracts, eligible margin loans, or repo-style transactions; and
(ii) The bank obtains a written legal opinion verifying the
validity and enforceability of the netting agreement under applicable
law of the relevant jurisdictions if the counterparty fails to perform
upon an event of default, including upon an event of bankruptcy,
insolvency, or similar proceeding.
Banks use several measures to manage their exposure to counterparty
credit risk including PFE, expected exposure (EE), and expected
positive exposure (EPE). PFE is the maximum exposure estimated to occur
on a future date at a high level of statistical confidence. Banks often
use PFE when measuring counterparty credit risk exposure against
counterparty credit limits. EE is the probability-weighted average
exposure to a counterparty estimated to exist at any specified future
date, whereas EPE is the time-weighted average of individual expected
exposures estimated for a given forecasting horizon (one year in the
proposed rule). Banks typically compute EPE, EE, and PFE using a common
stochastic model.
A paper published by the BCBS in July 2005 titled ``The Application
of Basel II to Trading Activities and the Treatment of Double Default
Effects'' notes that EPE is an appropriate EAD measure for determining
risk-based capital requirements for counterparty credit risk because
transactions with counterparty credit risk ``are given the same
standing as loans with the goal of reducing the capital treatment's
influence on a firm's decision to extend an on-balance sheet loan
rather than engage in an economically equivalent transaction that
involves exposure to counterparty credit risk.''\63\ An adjustment to
EPE, called effective EPE and described below, is used in the
calculation of EAD under the internal models methodology. EAD is
calculated as a multiple of effective EPE.
---------------------------------------------------------------------------
\63\ BCBS, ``The Application of Basel II to Trading Activities
and the Treatment of Double Default Effects,'' July 2005, ] 15.
---------------------------------------------------------------------------
To address the concern that EE and EPE may not capture risk arising
from the replacement of existing short-term positions over the one year
horizon used for capital requirements (that is, rollover risk) or may
underestimate the exposures of eligible margin loans, repo-style
transactions, and OTC derivatives
[[Page 55874]]
with short maturities, the proposed rule uses a netting set's
``effective EPE'' as the basis for calculating EAD for counterparty
credit risk. Consistent with the use of a one-year PD horizon,
effective EPE is the time-weighted average of effective EE over one
year where the weights are the proportion that an individual effective
EE represents in a one-year time interval. If all contracts in a
netting set mature before one year, effective EPE is the average of
effective EE until all contracts in the netting set mature. For
example, if the longest maturity contract in the netting set matures in
six months, effective EPE would be the average of effective EE over six
months.
Effective EE is defined as:
Effective EE tk = max(Effective EE tk-1, EE tk) where exposure is
measured at future dates t1, t2, t3, * * * and effective EE t0 equals
current exposure. Alternatively, a bank may use a measure that is more
conservative than effective EPE for every counterparty (that is, a
measure based on peak exposure) with prior approval of the primary
Federal supervisor.
The EAD for instruments with counterparty credit risk must be
determined assuming economic downturn conditions. To accomplish this
determination in a prudent manner, the internal models methodology sets
EAD equal to EPE multiplied by a scaling factor termed ``alpha.'' Alpha
is set at 1.4; a bank's primary Federal supervisor would have the
flexibility to raise this value based on the bank's specific
characteristics of counterparty credit risk. With supervisory approval,
a bank may use its own estimate of alpha as described below, subject to
a floor of 1.2. Question 39: The agencies request comment on all aspect
of the effective EPE approach to counterparty credit risk, and in
particular on the appropriateness of the monotonically increasing
effective EE function, the alpha constant of 1.4, and the floor on
internal estimates of alpha of 1.2.
A bank's primary Federal supervisor must determine that the bank
meets certain qualifying criteria before the bank may use the internal
models methodology. These criteria consist of operational requirements,
modeling standards, and model validation requirements.
First, the bank must have the systems capability to estimate EE on
a daily basis. While this requirement does not require the bank to
report EE daily, or even estimate EE daily, the bank must demonstrate
that it is capable of performing the estimation daily.
Second, the bank must estimate EE at enough future time points to
accurately reflect all future cash flows of contracts in the netting
set. To accurately reflect the exposure arising from a transaction, the
model should incorporate those contractual provisions, such as reset
dates, that can materially affect the timing, probability, or amount of
any payment. The requirement reflects the need for an accurate estimate
of EPE. However, in order to balance the ability to calculate exposures
with the need for information on timely basis, the number of time
points is not specified.
Third, the bank must have been using an internal model that broadly
meets the minimum standards to calculate the distributions of exposures
upon which the EAD calculation is based for a period of at least one
year prior to approval. This requirement is to insure that the bank has
integrated the modeling into its counterparty credit risk management
process.
Fourth, the bank's model must account for the non-normality of
exposure distribution where appropriate. Non-normality of exposures
means high loss events occur more frequently than would be expected on
the basis of a normal distribution, the statistical term for which is
leptokurtosis. In many instances, there may not be a need to account
for this. Expected exposures are much less likely to be affected by
leptokurtosis than peak exposures or high percentile losses. However,
the bank must demonstrate that its EAD measure is not affected by
leptokurtosis or must account for it within the model.
Fifth, the bank must measure, monitor, and control the exposure to
a counterparty over the whole life of all contracts in the netting set,
in addition to accurately measuring and actively monitoring the current
exposure to counterparties. The bank should exercise active management
of both existing exposure and exposure that could change in the future
due to market moves.
Sixth, the bank must measure and manage current exposures gross and
net of collateral held, where appropriate. The bank must estimate
expected exposures for OTC derivative contracts both with and without
the effect of collateral agreements.
Seventh, the bank must have procedures to identify, monitor, and
control specific wrong-way risk throughout the life of an exposure. In
this context, wrong-way risk is the risk that future exposure to a
counterparty will be high when the counterparty's probability of
default is also high. Wrong-way risk generally arises from events
specific to the counterparty, rather than broad market downturns.
Eighth, the data used by the bank should be adequate for the
measurement and modeling of the exposures. In particular, current
exposures must be calculated on the basis of current market data. When
historical data are used to estimate model parameters, at least three
years of data that cover a wide range of economic conditions must be
used. This requirement reflects the longer horizon for counterparty
credit risk exposures compared to market risk exposures. The data must
be updated at least quarterly. Banks are encouraged also to incorporate
model parameters based on forward looking measures `` for example,
using implied volatilities in situations where historic volatilities
may not capture changes in the risk drivers anticipated by the market--
where appropriate.
Ninth, the bank must subject its models used in the calculation of
EAD to an initial validation and annual model review process. The model
review should consider whether the inputs and risk factors, as well as
the model outputs, are appropriate. The review of outputs should
include a rigorous program of backtesting model outputs against
realized exposures.
Maturity under the internal models methodology. Like corporate loan
exposures, counterparty exposure on netting sets is susceptible to
changes in economic value that stem from deterioration in the
counterparty's creditworthiness short of default. The effective
maturity parameter (M) reflects the impact of these changes on capital.
The formula used to compute M for netting sets with maturities greater
than one year must be different than that generally applied to
wholesale exposures in order to reflect how counterparty credit
exposures change over time. The proposed approach is based on a
weighted average of expected exposures over the life of the
transactions relative to their one year exposures.
If the remaining maturity of the exposure or the longest-dated
contract contained in a netting set is greater than one year, the bank
must set M for the exposure or netting set equal to the lower of 5
years or M(EPE), where:
[[Page 55875]]
[GRAPHIC] [TIFF OMITTED] TP25SE06.040
and (ii) df k is the risk-free discount factor for future
time period t k. The cap of five years on M is consistent
with the treatment of wholesale exposures under section 31 o the
proposed rule.
If the remaining maturity of the exposure or the longest-dated
contract in the netting set is one year or less, the bank must set M
for the exposure or netting set equal to 1 year except as provided in
section 31(d)(7) of the proposed rule. In this case, repo-style
transactions, eligible margin loans, and collateralized OTC derivative
transactions subject to daily remargining agreements may use the
effective maturity of the longest maturity transaction in the netting
set as M.
Collateral agreements under the internal models methodology. If the
bank has prior written approval from its primary Federal supervisor, it
may capture the effect on EAD of a collateral agreement that requires
receipt of collateral when exposure to the counterparty increases
within its internal model. In no circumstances may the bank take into
account in EAD collateral agreements triggered by deterioration of
counterparty credit quality. For this purpose, a collateral agreement
means a legal contract that: (i) Specifies the time when, and
circumstances under which, the counterparty is required to exchange
collateral with the bank for a single financial contract or for all
financial contracts covered under a qualifying master netting
agreement; and (ii) confers upon the bank a perfected, first priority
security interest, or the legal equivalent thereof, in the collateral
posted by the counterparty under the agreement. This security interest
must provide the bank with a right to close out the financial positions
and the collateral upon an event of default of or failure to perform by
the counterparty under the collateral agreement. A contract would not
satisfy this requirement if the bank's exercise of rights under the
agreement may be stayed or avoided under applicable law in the relevant
jurisdictions.
If the internal model does not capture the effects of collateral
agreements, the following ``shortcut'' method is proposed that will
provide some benefit, in the form of a smaller EAD, for collateralized
counterparties. Although this ``shortcut'' method will be permitted,
the agencies expect banks that make extensive use of collateral
agreements to develop the modeling capacity to measure the impact of
such agreements on EAD.
The ``shortcut'' method sets effective EPE for a counterparty
subject to a collateral agreement equal to the lesser of:
(i) The threshold, defined as the exposure amount at which the
counterparty is required to post collateral under the collateral
agreement, if the threshold is positive, plus an add-on that reflects
the potential increase in exposure over the margin period of risk. The
add-on is computed as the expected increase in the netting set's
exposure beginning from current exposure of zero over the margin period
of risk; and
(ii) Effective EPE without a collateral agreement.
The margin period of risk means, with respect to a netting set
subject to a collateral agreement, the time period from the most recent
exchange of collateral with a counterparty until the next required
exchange of collateral plus the period of time required to sell and
realize the proceeds of the least liquid collateral that can be
delivered under the terms of the collateral agreement, and, where
applicable, the period of time required to re-hedge the resulting
market risk, upon the default of the counterparty. The minimum margin
period of risk is 5 business days for repo-style transactions and 10
days for other transactions when liquid financial collateral is posted
under a daily margin maintenance requirement. This period should be
extended to cover any additional time between margin calls; any
potential closeout difficulties; any delays in selling collateral,
particularly if the collateral is illiquid; and any impediments to
prompt re-hedging of any market risk.
Own estimate of alpha. This proposed rule would allow a bank to
estimate a bank-wide alpha, subject to prior written approval from its
primary Federal supervisor. The internal estimate of alpha would be the
ratio of economic capital from a full simulation of counterparty credit
risk exposure that incorporates a joint simulation of market and credit
risk factors (numerator) to economic capital based on EPE
(denominator). For purposes of this calculation, economic capital is
the unexpected losses for all counterparty credit risks measured at the
99.9 percent confidence level over a one-year horizon. Internal
estimates of alpha are subject to a floor of 1.2. To obtain supervisory
approval to use an internal estimate of alpha in the calculation of
EAD, a bank must meet the following minimum standards to the
satisfaction of its primary Federal supervisor:
(i) The bank's own estimate of alpha must capture the effects in
the numerator of:
(A) The material sources of stochastic dependency of distributions
of market values of transactions or portfolios of transactions across
counterparties;
(B) Volatilities and correlations of market risk factors used in
the joint simulation, which must be related to the credit risk factor
used in the simulation to reflect potential increases in volatility or
correlation in an economic downturn, where appropriate; and
(C) The granularity of exposures, that is, the effect of a
concentration in the proportion of each counterparty's exposure that is
driven by a particular risk factor;
(ii) The bank must assess the potential model risk in its estimates
of alpha;
(iii) The bank must calculate the numerator and denominator of
alpha in a consistent fashion with respect to modeling methodology,
parameter specifications, and portfolio composition; and
(iv) The bank must review and adjust as appropriate its estimates
of the numerator and denominator on at least a quarterly basis and more
frequently as appropriate when the composition of the portfolio varies
over time.
Alternative models. The proposed rule allows a bank to use an
alternative model to determine EAD, provided that the bank can
demonstrate to its primary Federal supervisor that the model output is
more conservative than an alpha of 1.4 (or higher) times effective EPE.
This may be appropriate where a new product or business line is being
developed, where a recent acquisition has occurred, or where the bank
believes that other more conservative methods to measure counterparty
credit risk for a category of transactions are prudent. The alternative
method should be applied to all similar transactions. When an
alternative model is used, the
[[Page 55876]]
bank should either treat the particular transactions concerned as a
separate netting set with the counterparty or apply the alternative
model to the entire original netting set.
5. Guarantees and Credit Derivatives That Cover Wholesale Exposures
The New Accord specifies that a bank may adjust either the PD or
the LGD of a wholesale exposure to reflect the risk mitigating effects
of a guarantee or credit derivative. Under the proposed rule, a bank
may choose either a PD substitution or an LGD adjustment approach to
recognize the risk mitigating effects of an eligible guarantee or
eligible credit derivative on a wholesale exposure (or in certain
circumstances may choose to use a double default treatment, as
discussed below). In all cases a bank must use the same risk parameters
for calculating ECL for a wholesale exposure as it uses for calculating
the risk-based capital requirement for the exposure. Moreover, in all
cases, a bank's ultimate PD and LGD for the hedged wholesale exposure
may not be lower than the PD and LGD floors discussed above and
described in section 31(d) of the proposed rule.
Eligible guarantees and eligible credit derivatives. To be
recognized as CRM for a wholesale exposure under the proposed rule,
guarantees and credit derivatives must meet specific eligibility
requirements. The proposed rule defines an eligible guarantee as a
guarantee that:
(i) Is written and unconditional;
(ii) Covers all or a pro rata portion of all contractual payments
of the obligor on the reference exposure;
(iii) Gives the beneficiary a direct claim against the protection
provider;
(iv) Is non-cancelable by the protection provider for reasons other
than the breach of the contract by the beneficiary;
(v) Is legally enforceable against the protection provider in a
jurisdiction where the protection provider has sufficient assets
against which a judgment may be attached and enforced; and
(vi) Requires the protection provider to make payment to the
beneficiary on the occurrence of a default (as defined in the
guarantee) of the obligor on the reference exposure without first
requiring the beneficiary to demand payment from the obligor. Clearly,
a bank could not provide an eligible guarantee on its own exposures.
The proposed rule defines an eligible credit derivative as a credit
derivative in the form of a credit default swap, nth-to-default swap,
or total return swap provided that:
(i) The contract meets the requirements of an eligible guarantee
and has been confirmed by the protection purchaser and the protection
provider;
(ii) Any assignment of the contract has been confirmed by all
relevant parties;
(iii) If the credit derivative is a credit default swap or nth-to-
default swap, the contract includes the following credit events:
(A) Failure to pay any amount due under the terms of the reference
exposure (with a grace period that is closely in line with the grace
period of the reference exposure); and
(B) Bankruptcy, insolvency, or inability of the obligor on the
reference exposure to pay its debts, or its failure or admission in
writing of its inability generally to pay its debts as they become due,
and similar events;
(iv) The terms and conditions dictating the manner in which the
contract is to be settled are incorporated into the contract;
(v) If the contract allows for cash settlement, the contract
incorporates a robust valuation process to estimate loss reliably and
specifies a reasonable period for obtaining post-credit event
valuations of the reference exposure;
(vi) If the contract requires the protection purchaser to transfer
an exposure to the protection provider at settlement, the terms of the
exposure provide that any required consent to transfer may not be
unreasonably withheld;
(vii) If the credit derivative is a credit default swap or nth-to-
default swap, the contract clearly identifies the parties responsible
for determining whether a credit event has occurred, specifies that
this determination is not the sole responsibility of the protection
provider, and gives the protection purchaser the right to notify the
protection provider of the occurrence of a credit event; and
(viii) If the credit derivative is a total return swap and the bank
records net payments received on the swap as net income, the bank
records offsetting deterioration in the value of the hedged exposure
(either through reductions in fair value or by an addition to
reserves).
Question 40: The agencies request comment on the appropriateness of
these criteria in determining whether the risk mitigation effects of a
credit derivative should be recognized for risk-based capital purposes.
Under the proposed rule, a bank may recognize an eligible credit
derivative that hedges an exposure that is different from the credit
derivative's reference exposure used for determining the derivative's
cash settlement value, deliverable obligation, or occurrence of a
credit event only if:
(i) The reference exposure ranks pari passu (that is, equal) or
junior to the hedged exposure; and
(ii) The reference exposure and the hedged exposure share the same
obligor (that is, the same legal entity) and legally enforceable cross-
default or cross-acceleration clauses are in place.
PD substitution approach. Under the PD substitution approach, if
the protection amount (as defined below) of the eligible guarantee or
eligible credit derivative is greater than or equal to the EAD of the
hedged exposure, a bank would substitute for the PD of the hedged
exposure the PD associated with the rating grade of the protection
provider. If the bank determines that full substitution leads to an
inappropriate degree of risk mitigation, the bank may substitute a
higher PD for that of the protection provider.
If the guarantee or credit derivative provides the bank with the
option to receive immediate payout on triggering the protection, then
the bank would use the lower of the LGD of the hedged exposure (not
adjusted to reflect the guarantee or credit derivative) and the LGD of
the guarantee or credit derivative. The bank also would use the ELGD
associated with the required LGD. If the guarantee or credit derivative
does not provide the bank with the option to receive immediate payout
on triggering the protection (and instead provides for the guarantor to
assume the payment obligations of the obligor over the remaining life
of the hedged exposure), the bank would use the LGD and ELGD of the
guarantee or credit derivative.
If the protection amount of the eligible guarantee or eligible
credit derivative is less than the EAD of the hedged exposure, however,
the bank must treat the hedged exposure as two separate exposures
(protected and unprotected) in order to recognize the credit risk
mitigation benefit of the guarantee or credit derivative. The bank must
calculate its risk-based capital requirement for the protected exposure
under section 31 of the proposed rule (using a PD equal to the
protection provider's PD, an ELGD and LGD determined as described
above, and an EAD equal to the protection amount of the guarantee or
credit derivative). If the bank determines that full substitution leads
to an inappropriate degree of risk mitigation, the bank may use a
higher PD than that of the protection provider. The bank must calculate
its risk-based capital requirement for the unprotected exposure under
section 31 of the proposed rule (using a PD equal to the
[[Page 55877]]
obligor's PD, an ELGD and LGD equal to the hedged exposure's ELGD and
LGD not adjusted to reflect the guarantee or credit derivative, and an
EAD equal to the EAD of the original hedged exposure minus the
protection amount of the guarantee or credit derivative).
The protection amount of an eligible guarantee or eligible credit
derivative would be the effective notional amount of the guarantee or
credit derivative reduced by any applicable haircuts for maturity
mismatch, lack of restructuring, and currency mismatch (each described
below). The effective notional amount of a guarantee or credit
derivative would be the lesser of the contractual notional amount of
the credit risk mitigant and the EAD of the hedged exposure, multiplied
by the percentage coverage of the credit risk mitigant. For example,
the effective notional amount of a guarantee that covers, on a pro rata
basis, 40 percent of any losses on a $100 bond would be $40.
LGD adjustment approach. Under the LGD adjustment approach, if the
protection amount of the eligible guarantee or eligible credit
derivative is greater than or equal to the EAD of the hedged exposure,
the bank's risk-based capital requirement for the hedged exposure would
be the greater of (i) the risk-based capital requirement for the
exposure as calculated under section 31 of the proposed rule (with the
ELGD and LGD of the exposure adjusted to reflect the guarantee or
credit derivative); or (ii) the risk-based capital requirement for a
direct exposure to the protection provider as calculated under section
31 of the proposed rule (using the bank's PD for the protection
provider, the bank's ELGD and LGD for the guarantee or credit
derivative, and an EAD equal to the EAD of the hedged exposure).
If the protection amount of the eligible guarantee or eligible
credit derivative is less than the EAD of the hedged exposure, however,
the bank must treat the hedged exposure as two separate exposures
(protected and unprotected) in order to recognize the credit risk
mitigation benefit of the guarantee or credit derivative. The bank's
risk-based capital requirement for the protected exposure would be the
greater of (i) the risk-based capital requirement for the protected
exposure as calculated under section 31 of the proposed rule (with the
ELGD and LGD of the exposure adjusted to reflect the guarantee or
credit derivative and EAD set equal to the protection amount of the
guarantee or credit derivative); or (ii) the risk-based capital
requirement for a direct exposure to the protection provider as
calculated under section 31 of the proposed rule (using the bank's PD
for the protection provider, the bank's ELGD and LGD for the guarantee
or credit derivative, and an EAD set equal to the protection amount of
the guarantee or credit derivative). The bank must calculate its risk-
based capital requirement for the unprotected exposure under section 31
of the proposed rule using a PD set equal to the obligor's PD, an ELGD
and LGD set equal to the hedged exposure's ELGD and LGD (not adjusted
to reflect the guarantee or credit derivative), and an EAD set equal to
the EAD of the original hedged exposure minus the protection amount of
the guarantee or credit derivative.
The PD substitution approach allows a bank to effectively assess
risk-based capital against a hedged exposure as if it were a direct
exposure to the protection provider, and the LGD adjustment approach
produces a risk-based capital requirement for a hedged exposure that is
never lower than that of a direct exposure to the protection provider.
Accordingly, these approaches do not fully reflect the risk mitigation
benefits certain types of guarantees and credit derivatives may provide
because the resulting risk-based capital requirement does not consider
the joint probability of default of the obligor of the hedged exposure
and the protection provider, sometimes referred to as the ``double
default'' benefit. The agencies have decided, consistent with the New
Accord, to recognize double default benefits in the wholesale framework
only for certain hedged exposures covered by certain guarantees and
credit derivatives. A later section of the preamble describes which
hedged exposures would be eligible for the proposed double default
treatment and describes the double default treatment that would be
available to those exposures.
Maturity mismatch haircut. A bank that seeks to reduce the risk-
based capital requirement on a wholesale exposure by recognizing an
eligible guarantee or eligible credit derivative would have to adjust
the protection amount of the credit risk mitigant downward to reflect
any maturity mismatch between the hedged exposure and the credit risk
mitigant. A maturity mismatch occurs when the effective residual
maturity of a credit risk mitigant is less than that of the hedged
exposure(s). When the hedged exposures have different residual
maturities, the longest residual maturity of any of the hedged
exposures would be used as the residual maturity of all hedged
exposures.
The effective residual maturity of a hedged exposure should be
gauged as the longest possible remaining time before the obligor is
scheduled to fulfil its obligation on the exposure. When determining
the effective residual maturity of the guarantee or credit derivative,
embedded options that may reduce the term of the credit risk mitigant
should be taken into account so that the shortest possible residual
maturity for the credit risk mitigant is used to determine the
potential maturity mismatch. Where a call is at the discretion of the
protection provider, the residual maturity of the guarantee or credit
derivative would be deemed to be at the first call date. If the call is
at the discretion of the bank purchasing the protection, but the terms
of the arrangement at inception of the guarantee or credit derivative
contain a positive incentive for the bank to call the transaction
before contractual maturity, the remaining time to the first call date
would be deemed to be the residual maturity of the credit risk
mitigant. For example, where there is a step-up in the cost of credit
protection in conjunction with a call feature or where the effective
cost of protection increases over time even if credit quality remains
the same or improves, the residual maturity of the credit risk mitigant
would be the remaining time to the first call.
Eligible guarantees and eligible credit derivatives with maturity
mismatches may only be recognized if their original maturities are
equal to or greater than one year. As a result, a guarantee or credit
derivative would not be recognized for a hedged exposure with an
original maturity of less than one year unless the credit risk mitigant
has an original maturity of equal to or greater than one year or an
effective residual maturity equal to or greater than that of the hedged
exposure. In all cases, credit risk mitigants with maturity mismatches
may not be recognized when they have an effective residual maturity of
three months or less.
When a maturity mismatch exists, a bank would apply the following
maturity mismatch adjustment to determine the protection amount of the
guarantee or credit derivative adjusted for maturity mismatch: Pm = E x
(t-0.25)/(T-0.25), where:
(i) Pm = protection amount of the guarantee or credit derivative
adjusted for maturity mismatch;
(ii) E = effective notional amount of the guarantee or credit
derivative;
(iii) t = lesser of T or effective residual maturity of the
guarantee or credit derivative, expressed in years; and
[[Page 55878]]
(iv) T = lesser of 5 or effective residual maturity of the hedged
exposure, expressed in years.
Restructuring haircut. An originating bank that seeks to recognize
an eligible credit derivative that does not include a distressed
restructuring as a credit event that triggers payment under the
derivative would have to reduce the recognition of the credit
derivative by 40 percent. A distressed restructuring is a restructuring
of the hedged exposure involving forgiveness or postponement of
principal, interest, or fees that results in a charge-off, specific
provision, or other similar debit to the profit and loss account.
In other words, the protection amount of the credit derivative
adjusted for lack of restructuring credit event (and maturity mismatch,
if applicable) would be: Pr = Pm x 0.60, where:
(i) Pr = protection amount of the credit derivative, adjusted for
lack of restructuring credit event (and maturity mismatch, if
applicable); and
(ii) Pm = effective notional amount of the credit derivative
(adjusted for maturity mismatch, if applicable).
Currency mismatch haircut. Where the eligible guarantee or eligible
credit derivative is denominated in a currency different from that in
which any hedged exposure is denominated, the protection amount of the
guarantee or credit derivative adjusted for currency mismatch (and
maturity mismatch and lack of restructuring credit event, if
applicable) would be: Pc = Pr x (1-Hfx), where:
(i) Pc = protection amount of the guarantee or credit derivative,
adjusted for currency mismatch (and maturity mismatch and lack of
restructuring credit event, if applicable);
(ii) Pr = effective notional amount of the guarantee or credit
derivative (adjusted for maturity mismatch and lack of restructuring
credit event, if applicable); and
(iii) Hfx = haircut appropriate for the currency mismatch between
the guarantee or credit derivative and the hedged exposure.
A bank may use a standard supervisory haircut of 8 percent for Hfx
(based on a 10-business day holding period and daily marking-to-market
and remargining). Alternatively, a bank may use internally estimated
haircuts for Hfx based on a 10-business day holding period and daily
marking-to-market and remargining if the bank qualifies to use the own-
estimates haircuts in paragraph (a)(2)(iii) of section 32, the simple
VaR methodology in paragraph (a)(3) of section 32, or the internal
models methodology in paragraph (c) of section 32 of the proposed rule.
The bank must scale these haircuts up using a square root of time
formula if the bank revalues the guarantee or credit derivative less
frequently than once every 10 business days.
Example. Assume that a bank holds a five-year $100 corporate
exposure, purchases a $100 credit derivative to mitigate its credit
risk on the exposure, and chooses to use the PD substitution
approach. The unsecured ELGD and LGD of the corporate exposure are
20 and 30 percent, respectively; the ELGD and LGD of the credit
derivative are 75 and 80 percent, respectively. The credit
derivative is an eligible credit derivative, has the bank's exposure
as its reference exposure, has a three-year maturity, immediate cash
payout on default, no restructuring provision, and no currency
mismatch with the bank's hedged exposure. The effective notional
amount and initial protection amount of the credit derivative would
be $100. The maturity mismatch would reduce the protection amount to
$100 x (3-.25)/(5-.25) or $57.89. The haircut for lack of
restructuring would reduce the protection amount to $57.89 x 0.6 or
$34.74. So the bank would treat the $100 corporate exposure as two
exposures: (i) An exposure of $34.74 with the PD of the protection
provider, an ELGD of 20 percent, an LGD of 30 percent, and an M of
5; and (ii) an exposure of $65.26 with the PD of the obligor, an
ELGD of 20 percent, an LGD of 30 percent, and an M of 5.
Multiple credit risk mitigants. The New Accord provides that if
multiple credit risk mitigants (for example, two eligible guarantees)
cover a single exposure, a bank must disaggregate the exposure into
portions covered by each credit risk mitigant (for example, the portion
covered by each guarantee) and must calculate separately the risk-based
capital requirement of each portion.\64\ The New Accord also indicates
that when credit risk mitigants provided by a single protection
provider have differing maturities, they should be subdivided into
separate layers of protection.\65\ Question 41: The agencies are
interested in the views of commenters as to whether and how the
agencies should address these and other similar situations in which
multiple credit risk mitigants cover a single exposure.
---------------------------------------------------------------------------
\64\ New Accord, ] 206.
\65\ Id.
---------------------------------------------------------------------------
Double default treatment. As noted above, the proposed rule
contains a separate risk-based capital methodology for hedged exposures
eligible for double default treatment. To be eligible for double
default treatment, a hedged exposure must be fully covered or covered
on a pro rata basis (that is, there must be no tranching of credit
risk) by an uncollateralized single-reference-obligor credit derivative
or guarantee (or certain nth-to-default credit derivatives) provided by
an eligible double default guarantor (as defined below). Moreover, the
hedged exposure must be a wholesale exposure other than a sovereign
exposure.\66\ In addition, the obligor of the hedged exposure must not
be an eligible double default guarantor, an affiliate of an eligible
double default guarantor, or an affiliate of the guarantor.
---------------------------------------------------------------------------
\66\ The New Accord permits certain retail small business
exposures to be eligible for double default treatment. Under this
proposal, however, a bank must effectively desegment a retail small
business exposure (thus rendering it a wholesale exposure) to make
it eligible for double default treatment.
---------------------------------------------------------------------------
The proposed rule defines eligible double default guarantor to
include a depository institution (as defined in section 3 of the
Federal Deposit Insurance Act (12 U.S.C. 1813)); a bank holding company
(as defined in section 2 of the Bank Holding Company Act (12 U.S.C.
1841)); a savings and loan holding company (as defined in 12 U.S.C.
1467a) provided all or substantially all of the holding company's
activities are permissible for a financial holding company under 12
U.S.C. 1843(k)); a securities broker or dealer registered (under the
Securities Exchange Act of 1934) with the Securities and Exchange
Commission (SEC); an insurance company in the business of providing
credit protection (such as a monoline bond insurer or re-insurer) that
is subject to supervision by a state insurance regulator; a foreign
bank (as defined in section 211.2 of the Federal Reserve Board's
Regulation K (12 CFR 211.2)); a non-U.S. securities firm; or a non-U.S.
based insurance company in the business of providing credit protection.
To be an eligible double default guarantor, the entity must (i) have a
bank-assigned PD that, at the time the guarantor issued the guarantee
or credit derivative, was equal to or lower than the PD associated with
a long-term external rating of at least the third highest investment
grade rating category; and (ii) have a current bank-assigned PD that is
equal to or lower than the PD associated with a long-term external
rating of at least investment grade. In addition, a non-U.S. based
bank, securities firm, or insurance company may qualify as an eligible
double default guarantor only if the firm is subject to consolidated
supervision and regulation comparable to that imposed on U.S.
depository institutions, securities firms, or insurance companies (as
the case may be) or has issued and outstanding an unsecured long-term
debt security without credit enhancement that has a long-term
applicable external rating in one of the
[[Page 55879]]
three highest investment grade rating categories.
Effectively, the scope of an eligible double default guarantor is
limited to financial firms whose normal business includes the provision
of credit protection, as well as the management of a diversified
portfolio of credit risk. This restriction arises from the agencies'
concern to limit double default recognition to professional
counterparties that have a high level of credit risk management
expertise and that provide sufficient market disclosure. The
restriction is also designed to limit the risk of excessive correlation
between the creditworthiness of the guarantor and the obligor of the
hedged exposure due to their performance depending on common economic
factors beyond the systematic risk factor. As a result, hedged
exposures to potential credit protection providers or affiliates of
credit protection providers would not be eligible for the double
default treatment. In addition, the agencies have excluded hedged
exposures to sovereign entities from eligibility for double default
treatment because of the potential high correlation between the
creditworthiness of a sovereign and that of a guarantor.
In addition to limiting the types of guarantees, credit
derivatives, guarantors, and hedged exposures eligible for double
default treatment, the proposed rule limits wrong-way risk further by
requiring a bank to implement a process to detect excessive correlation
between the creditworthiness of the obligor of the hedged exposure and
the protection provider. The bank must receive prior written approval
from its primary Federal supervisor for this process in order to
recognize double default benefits for risk-based capital purposes. To
apply double default treatment to a particular hedged exposure, the
bank must determine that there is not excessive correlation between the
creditworthiness of the obligor of the hedged exposure and the
protection provider. For example, the creditworthiness of an obligor
and a protection provider would be excessively correlated if the
obligor derives a high proportion of its income or revenue from
transactions with the protection provider. If excessive correlation is
present, the bank may not use the double default treatment for the
hedged exposure.
The risk-based capital requirement for a hedged exposure subject to
double default treatment is calculated by multiplying a risk-based
capital requirement for the hedged exposure (as if it were unhedged) by
an adjustment factor that considers the PD of the protection provider
(see section 34 of the proposed rule). Thus, the PDs of both the
obligor of the hedged exposure and the protection provider are factored
into the hedged exposure's risk-based capital requirement. In addition,
as under the PD substitution treatment in section 33 of the proposed
rule, the bank would be allowed to set LGD equal to the lower of the
LGD of the unhedged exposure or the LGD of the guarantee or credit
derivative if the guarantee or credit derivative provides the bank with
the option to receive immediate payout on the occurrence of a credit
event. Otherwise, the bank must set LGD equal to the LGD of the
guarantee or credit derivative. In addition, the bank must set ELGD
equal to the ELGD associated with the required LGD. Accordingly, in
order to apply the double default treatment, the bank must estimate a
PD for the protection provider and an ELGD and LGD for the guarantee or
credit derivative. Finally, a bank using the double default treatment
must make applicable adjustments to the protection amount of the
guarantee or credit derivative to reflect maturity mismatches, currency
mismatches, and lack of restructuring coverage (as under the PD
substitution and LGD adjustment approaches in section 33 of the
proposed rule).
6. Guarantees and Credit Derivatives That Cover Retail Exposures
The proposed rule provides a different treatment for guarantees and
credit derivatives that cover retail exposures. The approach set forth
above for guarantees and credit derivatives that cover wholesale
exposures is an exposure-by-exposure approach consistent with the
overall exposure-by-exposure approach the proposed rule takes to
wholesale exposures. The agencies believe that a different treatment
for guarantees that cover retail exposures is necessary and appropriate
because of the proposed rule's segmentation approach to retail
exposures. The approaches to retail guarantees described in this
section generally apply only to guarantees of individual retail
exposures. Guarantees of multiple retail exposures (such as pool
private mortgage insurance (PMI)) are typically tranched (that is, they
cover less than the full amount of the hedged exposures) and,
therefore, would be securitization exposures.
The proposed rule does not specify the ways in which guarantees and
credit derivatives may be taken into account in the segmentation of
retail exposures. Likewise, the proposed rule does not explicitly limit
the extent to which a bank may take into account the credit risk
mitigation benefits of guarantees and credit derivatives in its
estimation of the PD, ELGD, and LGD of retail segments, except by the
application of overall floors on certain PD and LGD assignments. This
approach has the principal advantage of being relatively easy for banks
to implement--the approach generally would not disrupt the existing
retail segmentation practices of banks and would not interfere with
banks' quantification of PD, ELGD, and LGD for retail segments. The
agencies are concerned, however, that because this approach would
provide banks with substantial discretion to incorporate double default
and double recovery effects, the resulting treatment for guarantees of
retail exposures would be inconsistent with the treatment for
guarantees of wholesale exposures.
To address these concerns, the agencies are considering for
purposes of the final rule two principal alternative treatments for
guarantees of retail exposures. The first alternative would distinguish
between eligible retail guarantees and all other (non-eligible)
guarantees of retail exposures. Under this alternative, an eligible
retail guarantee would be an eligible guarantee that applies to a
single retail exposure and is (i) PMI issued by an insurance company
that (A) has issued a senior unsecured long-term debt security without
credit enhancement that has an applicable external rating in one of the
two highest investment grade rating categories or (B) has a claims
payment ability that is rated in one of the two highest rating
categories by an NRSRO; or (ii) issued by a sovereign entity or a
political subdivision of a sovereign entity. Under this alternative,
PMI would be defined as insurance provided by a regulated mortgage
insurance company that protects a mortgage lender in the event of the
default of a mortgage borrower up to a predetermined portion of the
value of a single one-to four-family residential property.
Under this alternative, a bank would be able to recognize the
credit risk mitigation benefits of eligible retail guarantees that
cover retail exposures in a segment by adjusting its estimates of ELGD
and LGD for the segment to reflect recoveries from the guarantor.
However, the bank would have to estimate the PD of a segment without
reflecting the benefit of guarantees; that is, a segment's PD would be
an estimate of the stand-alone probability of default for the retail
exposures in the segment, before taking account of any guarantees.
[[Page 55880]]
Accordingly, for this limited set of traditional guarantees of retail
exposures by high credit quality guarantors, a bank would be allowed to
recognize the benefit of the guarantee when estimating ELGD and LGD,
but not when estimating PD. Question 42: The agencies seek comment on
this alternative approach's definition of eligible retail guarantee and
treatment for eligible retail guarantees, and on whether the agencies
should provide similar treatment for any other forms of wholesale
credit insurance or guarantees on retail exposures, such as student
loans, if the agencies adopt this approach.
This alternative approach would provide a different treatment for
non-eligible retail guarantees. In short, within the retail framework,
a bank would not be able to recognize non-eligible retail guarantees
when estimating PD, ELGD, and LGD for any segment of retail exposures.
In other words, a bank would be required to estimate PD, ELGD, and LGD
for segments containing retail exposures with non-eligible guarantees
as if the exposures were not guaranteed. However, a bank would be
permitted to recognize non-eligible retail guarantees provided by a
wholesale guarantor by treating the hedged retail exposure as a direct
exposure to the guarantor and applying the appropriate wholesale IRB
risk-based capital formula. In other words, for retail exposures
covered by non-eligible retail guarantees, a bank would be permitted to
reflect the guarantee by ``desegmenting'' the retail exposures (which
effectively would convert the retail exposures into wholesale
exposures) and then applying the rules set forth above for guarantees
that cover wholesale exposures. Thus, under this approach, a bank would
not be allowed to recognize either double default or double recovery
effects for non-eligible retail guarantees.
The agencies understand that this approach to non-eligible retail
guarantees, while addressing the prudential concerns of the agencies,
is conservative and may not harmonize with banks' internal risk
measurement and management practices in this area. Question 43: The
agencies seek comment on the types of non-eligible retail guarantees
banks obtain and the extent to which banks obtain credit risk
mitigation in the form of non-eligible retail guarantees.
A second alternative that the agencies are considering for purposes
of the final rule would permit a bank to recognize the credit risk
mitigation benefits of all eligible guarantees (whether eligible retail
guarantees or not) that cover retail exposures by adjusting its
estimates of ELGD and LGD for the relevant segments, but would subject
a bank's risk-based capital requirement for a segment of retail
exposures that are covered by one or more non-eligible retail
guarantees to a floor. Under this second alternative, the agencies
could impose a floor on risk-based capital requirements of between 2
percent and 6 percent on such a segment of retail exposures.
Question 44: The agencies seek comment on both of these alternative
approaches to guarantees that cover retail exposures. The agencies also
invite comment on other possible prudential treatments for such
guarantees.
D. Unsettled Securities, Foreign Exchange, and Commodity Transactions
Section 35 of the proposed rule sets forth the risk-based capital
requirements for unsettled and failed securities, foreign exchange, and
commodities transactions. Certain transaction types are excluded from
the scope of this section, including:
(i) Transactions accepted by a qualifying central counterparty that
are subject to daily marking-to-market and daily receipt and payment of
variation margin (which do not have a risk-based capital
requirement);\67\
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\67\ The agencies consider a qualifying central counterparty to
be the functional equivalent of an exchange, and have long exempted
exchange-traded contracts from risk-based capital requirements.
Transactions rejected by a qualifying central counterparty (because,
for example, of a discrepancy in the details of the transaction such
as in quantity, price, or in the underlying security, between the
buyer and seller) potentially give rise to risk exposure to either
party.
---------------------------------------------------------------------------
(ii) Repo-style transactions (the risk-based capital requirements
of which are determined under sections 31 and 32 of the proposed rule);
(iii) One-way cash payments on OTC derivative contracts (the risk-
based capital requirements of which are determined under sections 31
and 32 of the proposed rule); and
(iv) Transactions with a contractual settlement period that is
longer than the normal settlement period (defined below), which
transactions are treated as OTC derivative contracts and assessed a
risk-based capital requirement under sections 31 and 32 of the proposed
rule. The proposed rule also provides that, in the case of a system-
wide failure of a settlement or clearing system, the bank's primary
Federal supervisor may waive risk-based capital requirements for
unsettled and failed transactions until the situation is rectified.
The proposed rule contains separate treatments for delivery-versus-
payment (DvP) and payment-versus-payment (PvP) transactions with a
normal settlement period, on the one hand, and non-DvP/non-PvP
transactions with a normal settlement period, on the other hand. The
proposed rule provides the following definitions of a DvP transaction,
a PvP transaction, and a normal settlement period. A DvP transaction is
a securities or commodities transaction in which the buyer is obligated
to make payment only if the seller has made delivery of the securities
or commodities and the seller is obligated to deliver the securities or
commodities only if the buyer has made payment. A PvP transaction is a
foreign exchange transaction in which each counterparty is obligated to
make a final transfer of one or more currencies only if the other
counterparty has made a final transfer of one or more currencies. A
transaction has a normal settlement period if the contractual
settlement period for the transaction is equal to or less than the
market standard for the instrument underlying the transaction and equal
to or less than five business days.
A bank must hold risk-based capital against a DvP or PvP
transaction with a normal settlement period if the bank's counterparty
has not made delivery or payment within five business days after the
settlement date. The bank must determine its risk-weighted asset amount
for such a transaction by multiplying the positive current exposure of
the transaction for the bank by the appropriate risk weight in Table F.
The positive current exposure of a transaction of a bank is the
difference between the transaction value at the agreed settlement price
and the current market price of the transaction, if the difference
results in a credit exposure of the bank to the counterparty.
Table F.--Risk Weights for Unsettled DvP and PvP Transactions
------------------------------------------------------------------------
Risk weight to
be applied to
Number of business days after contractual settlement positive
date current
exposure
(percent)
------------------------------------------------------------------------
From 5 to 15............................................ 100
From 16 to 30........................................... 625
From 31 to 45........................................... 937.5
46 or more.............................................. 1,250
------------------------------------------------------------------------
A bank must hold risk-based capital against any non-DvP/non-PvP
transaction with a normal settlement period if the bank has delivered
cash, securities, commodities, or currencies to its counterparty but
has not received its
[[Page 55881]]
corresponding deliverables by the end of the same business day. The
bank must continue to hold risk-based capital against the transaction
until the bank has received its corresponding deliverables. From the
business day after the bank has made its delivery until five business
days after the counterparty delivery is due, the bank must calculate
its risk-based capital requirement for the transaction by treating the
current market value of the deliverables owed to the bank as a
wholesale exposure.
A bank may assign an internal obligor rating to a counterparty for
which it is not otherwise required under the proposed rule to assign an
obligor rating on the basis of the applicable external rating of any
outstanding senior unsecured long-term debt security without credit
enhancement issued by the counterparty. A bank may estimate loss
severity ratings or ELGD and LGD for the exposure, or may use a 45
percent ELGD and LGD for the exposure provided the bank uses the 45
percent ELGD and LGD for all such exposures. Alternatively, a bank may
use a 100 percent risk weight for the exposure as long as the bank uses
this risk weight for all such exposures.
If, in a non-DvP/non-PvP transaction with a normal settlement
period, the bank has not received its deliverables by the fifth
business day after counterparty delivery was due, the bank must deduct
the current market value of the deliverables owed to the bank 50
percent from tier 1 capital and 50 percent from tier 2 capital.
The total risk-weighted asset amount for unsettled transactions
equals the sum of the risk-weighted asset amount for each DvP and PvP
transaction with a normal settlement period and the risk-weighted asset
amount for each non-DvP/non-PvP transaction with a normal settlement
period.
E. Securitization Exposures
This section describes the framework for calculating risk-based
capital requirements for securitization exposures under the proposed
rule (the securitization framework). In contrast to the proposed
framework for wholesale and retail exposures, the proposed
securitization framework does not permit a bank to rely on its internal
assessments of the risk parameters of a securitization exposure.\68\
For securitization exposures, which typically are tranched exposures to
a pool of underlying exposures, such assessments would require implicit
or explicit estimates of correlations among the losses on the
underlying exposures and estimates of the credit risk consequences of
tranching. Such correlation and tranching effects are difficult to
estimate and validate in an objective manner and on a going-forward
basis. Instead, the proposed securitization framework relies
principally on two sources of information, where available, to
determine risk-based capital requirements: (i) An assessment of the
securitization exposure's credit risk made by an NRSRO; or (ii) the
risk-based capital requirement for the underlying exposures as if the
exposures had not been securitized (along with certain other objective
information about the securitization exposure, such as the size and
relative seniority of the exposure).
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\68\ Although the Internal Assessment Approach described below
does allow a bank to use an internal-ratings-based approach to
determine its risk-based capital requirement for an exposure to an
ABCP program, banks are required to follow NRSRO rating criteria and
therefore are required implicitly to use the NRSRO's determination
of the correlation of the underlying exposures in the ABCP program.
---------------------------------------------------------------------------
A bank must use the securitization framework for exposures to any
transaction that involves the tranching of credit risk (with the
exception of a tranched guarantee that applies only to an individual
retail exposure), regardless of the number of underlying exposures in
the transaction.\69\ A single, unified approach to dealing with the
tranching of credit risk is important to create a level playing field
across the securitization, credit derivatives, and other financial
markets. The agencies believe that basing the applicability of the
proposed securitization framework on the presence of some minimum
number of underlying exposures would complicate the proposed rule
without any material improvement in risk sensitivity. The proposed
securitization framework is designed specifically to deal with tranched
exposures to credit risk, and the principal risk-based capital
approaches of the proposed securitization framework take into account
the effective number of underlying exposures.
---------------------------------------------------------------------------
\69\ As noted above, mortgage-backed pass-through securities
guaranteed by Fannie Mae or Freddie Mac are also securitization
exposures.
---------------------------------------------------------------------------
1. Hierarchy of Approaches
The proposed securitization framework contains three general
approaches for determining the risk-based capital requirement for a
securitization exposure: A Ratings-Based Approach (RBA), an Internal
Assessment Approach (IAA), and a Supervisory Formula Approach (SFA).
Under the proposed rule, banks generally must apply the following
hierarchy of approaches to determine the risk-based capital requirement
for a securitization exposure.
First, a bank must deduct from tier 1 capital any after-tax gain-
on-sale resulting from a securitization and must deduct from total
capital any portion of a CEIO that does not constitute a gain-on-sale,
as described in section 42(c) of the proposed rule. Second, a bank must
apply the RBA to a securitization exposure if the exposure qualifies
for the RBA. As a general matter, an exposure qualifies for the RBA if
the exposure has an external rating from an NRSRO or has an inferred
rating (that is, the exposure is senior to another securitization
exposure in the transaction that has an external rating from an NRSRO).
For example, a bank generally must use the RBA approach to determine
the risk-based capital requirement for an asset-backed security that
has an applicable external rating of AA+ from an NRSRO and for another
tranche of the same securitization that is unrated but senior in all
respects to the asset-backed security that was rated. In this example,
the senior unrated tranche would be treated as if it were rated AA+.
If a securitization exposure does not qualify for the RBA but is an
exposure to an ABCP program--such as a credit enhancement or liquidity
facility--the bank may apply the IAA (if the bank, the exposure, and
the ABCP program qualify for the IAA) or the SFA (if the bank and the
exposure qualify for the SFA) to the exposure. As a general matter, a
bank would qualify for use of the IAA if the bank establishes and
maintains an internal risk rating system for exposures to ABCP programs
that has been approved by the bank's primary Federal supervisor.
Alternatively, a bank may use the SFA if the bank is able to calculate
a set of risk factors relating to the securitization, including the
risk-based capital requirement for the underlying exposures as if they
were held directly by the bank. A bank that chooses to use the IAA must
use the IAA for all exposures that qualify for the IAA.
If a securitization exposure is not a gain-on-sale or a CEIO, does
not qualify for the RBA and is not an exposure to an ABCP program, the
bank may apply the SFA to the exposure if the bank is able to calculate
the SFA risk factors for the securitization. In many cases an
originating bank would use the SFA to determine its risk-based capital
requirements for retained securitization exposures. If a securitization
exposure is not a gain-on-sale or a CEIO and does not qualify for the
RBA, the IAA, or the SFA, the bank must deduct the exposure
[[Page 55882]]
from total capital. Total risk-weighted assets for securitization
exposures would be the sum of risk-weighted assets calculated under the
RBA, IAA, and SFA, plus any risk-weighted asset amounts calculated
under the early amortization provisions in section 47 of the proposed
rule.
Numerous commenters criticized the complexity of the ANPR's
treatment of approaches to securitization exposures and the different
treatment accorded to originating banks versus investing banks. As
discussed elsewhere in this section, the agencies have responded to
these comments by eliminating most of the differences in treatment for
originating banks and investing banks and by eliminating the
``Alternative RBA'' from the hierarchy of approaches. As discussed in
more detail below, there is one difference in treatment between
originating and investing banks in the RBA, consistent with the general
risk-based capital rules.
Some commenters expressed dissatisfaction that the ANPR required
banks to use the RBA to assess risk-based capital requirements against
a securitization exposure with an external or inferred rating. These
commenters argued that banks should be allowed to choose between the
RBA and the SFA when both approaches are available. The agencies have
not altered the proposed securitization framework to provide this
element of choice to banks because the agencies believe it would likely
create a means for regulatory capital arbitrage.
Exceptions to the general hierarchy of approaches. Under the
proposed securitization framework, unless one or more of the underlying
exposures does not meet the definition of a wholesale, retail,
securitization, or equity exposure, the total risk-based capital
requirement for all securitization exposures held by a single bank
associated with a single securitization (including any regulatory
capital requirement that relates to an early amortization provision,
but excluding any capital requirements that relate to the bank's gain-
on-sale or CEIOs associated with the securitization) cannot exceed the
sum of (i) the bank's total risk-based capital requirement for the
underlying exposures as if the bank directly held the underlying
exposures; and (ii) the bank's total ECL for the underlying exposures.
The ECL of the underlying exposures is included in this calculation
because if the bank held the underlying exposures on its balance sheet,
the bank would have had to estimate the ECL of the exposures and hold
reserves or capital against the ECL. This cap ensures that a bank's
effective risk-based capital requirement for exposure to a pool of
underlying exposures generally would not be greater than the applicable
risk-based capital requirement if the underlying exposures were held
directly by the bank, taking into consideration the agencies' safety
and soundness concerns with respect to CEIOs.
This proposed maximum risk-based capital requirement would be
different from the general risk-based capital rules. Under the general
risk-based capital rules, banks generally are required to hold a dollar
in capital for every dollar in residual interest, regardless of the
effective risk-based capital requirement on the underlying exposures.
The agencies adopted this dollar-for-dollar capital treatment for a
residual interest to recognize that in many instances the relative size
of the residual interest retained by the originating bank reveals
market information about the quality of the underlying exposures and
transaction structure that may not have been captured under the general
risk-based capital rules. Given the significantly heightened risk
sensitivity of the IRB framework, the agencies believe that the
proposed maximum risk-based capital requirement in the proposed
securitization framework is more appropriate.
In addition, the proposed rule would address various situations
involving overlapping exposures. Consistent with the general risk-based
capital rules, if a bank has multiple securitization exposures to an
ABCP program that provide duplicative coverage of the underlying
exposures of the program (such as when a bank provides a program-wide
credit enhancement and multiple pool-specific liquidity facilities to
an ABCP program), the bank is not required to hold duplicative risk-
based capital against the overlapping position. Instead, the bank would
apply to the overlapping position the applicable risk-based capital
treatment under the securitization framework that results in the
highest capital requirement. If different banks have overlapping
exposures to an ABCP program, however, each bank must hold capital
against the entire maximum amount of its exposure. Although duplication
of capital requirements will not occur for individual banks, some
systemic duplication may occur where multiple banks have overlapping
exposures to the same ABCP program.
The proposed rule also addresses overlapping exposures that arise
when a bank holds a securitization exposure in the form of a mortgage-
backed security or participation certificate that results from a
mortgage loan swap with recourse. In these situations, a bank must
determine a risk-based capital requirement for two separate exposures--
the retained recourse obligation on the swapped loans and the
percentage of the mortgage-backed security or participation certificate
that is not covered by the recourse obligation. The total risk-based
capital requirement is capped at the risk-based capital requirement for
the underlying exposures as if they were held directly on the bank's
balance sheet.
The proposed rule also addresses the risk-based capital treatment
of a securitization of non-IRB assets. Specifically, if a bank has a
securitization exposure and any underlying exposure of the
securitization is not a wholesale, retail, securitization or equity
exposure, the bank must (i) apply the RBA if the securitization
exposure qualifies for the RBA and is not gain-on-sale or a CEIO; or
(ii) otherwise, deduct the exposure from total capital. Music concert
and film receivables are examples of types of assets that are not
wholesale, retail, securitization, or equity exposures.
The proposed rule contains several additional exceptions to the
general hierarchy. For example, in light of the substantial volatility
in asset value related to prepayment risk and interest rate risk
associated with interest-only mortgage-backed securities, the proposed
rule provides that the risk weight for such a security may not be less
than 100 percent. In addition, the proposed rule follows the general
risk-based capital rules by allowing a sponsoring bank that qualifies
as a primary beneficiary and must consolidate an ABCP program as a
variable interest entity under GAAP to exclude the consolidated ABCP
program assets from risk-weighted assets. In such cases, the bank would
hold risk-based capital only against any securitization exposures of
the bank to the ABCP program.\70\ Moreover, the proposed rule follows
the general risk-based capital rules and a Federal statute \71\ by
including a special set of more lenient rules for the transfer of small
business loans and leases with recourse by well-capitalized depository
institutions.\72\
---------------------------------------------------------------------------
\70\ See Financial Accounting Standards Board, Interpretation
No. 46: Consolidation of Certain Variable Interest Entities (Jan.
2003).
\71\ See 12 U.S.C. 1835, which places a cap on the risk-based
capital requirement applicable to a well-capitalized depository
institution that transfers small business loans with recourse.
\72\ The proposed rule does not expressly state that the
agencies may permit adequately capitalized banks to use the small
business recourse rule on a case-by-case basis because the agencies
may do this under the general reservation of authority contained in
section 1 of the rule.
---------------------------------------------------------------------------
[[Page 55883]]
Servicer cash advances. A traditional securitization typically
employs a servicing bank that--on a day-to-day basis--collects
principal, interest, and other payments from the underlying exposures
of the securitization and forwards such payments to the securitization
SPE or to investors in the securitization. Such servicing banks often
provide to the securitization a credit facility under which the
servicing bank may advance cash to ensure an uninterrupted flow of
payments to investors in the securitization (including advances made to
cover foreclosure costs or other expenses to facilitate the timely
collection of the underlying exposures). These servicer cash advance
facilities are securitization exposures, and a servicing bank must
determine its risk-based capital requirement for the funded portion of
any such facility by using the proposed securitization framework.
Consistent with the general risk-based capital rules with respect
to residential mortgage servicer cash advances, however, a servicing
bank would not be required to hold risk-based capital against the
undrawn portion of an ``eligible'' servicer cash advance facility.
Under the proposed rule, an eligible servicer cash advance facility is
a servicer cash advance facility in which (i) the servicer is entitled
to full reimbursement of advances (except that a servicer may be
obligated to make non-reimburseable advances if any such advance with
respect to any underlying exposure is limited to an insignificant
amount of the outstanding principal balance of the underlying
exposure); (ii) the servicer's right to reimbursement is senior in
right of payment to all other claims on the cash flows from the
underlying exposures of the securitization; and (iii) the servicer has
no legal obligation to, and does not, make advances to the
securitization if the servicer concludes the advances are unlikely to
be repaid. If these conditions are not satisfied, a bank that provides
a servicer cash advance facility must determine its risk-based capital
requirement for the undrawn portion of the facility in the same manner
as the bank would determine its risk-based capital requirement for any
other undrawn securitization exposure.
Amount of a securitization exposure. For all of the securitization
approaches, the amount of an on-balance sheet securitization exposure
is the bank's carrying value, if the exposure is held-to-maturity or
for trading, or the bank's carrying value minus any unrealized gains
and plus any unrealized losses on the exposure, if the exposure is
available for sale. The amount of an off-balance sheet securitization
exposure is the notional amount of the exposure. For a commitment, such
as a liquidity facility extended to an ABCP program, the notional
amount may be reduced to the maximum potential amount that the bank
currently would be required to fund under the arrangement's
documentation (that is, the amount that could be drawn given the assets
held by the program). For an OTC derivative contract that is not a
credit derivative, the notional amount is the EAD of the derivative
contract (as calculated in section 32).
Implicit support. The proposed rule also sets forth the regulatory
capital consequences if a bank provides support to a securitization in
excess of the bank's predetermined contractual obligation to provide
credit support to the securitization. First, consistent with the
general risk-based capital rules,\73\ a bank that provides such
implicit support must hold regulatory capital against all of the
underlying exposures associated with the securitization as if the
exposures had not been securitized, and must deduct from tier 1 capital
any after-tax gain-on-sale resulting from the securitization. Second,
the bank must disclose publicly (i) that it has provided implicit
support to the securitization, and (ii) the regulatory capital impact
to the bank of providing the implicit support. The bank's primary
Federal supervisor also may require the bank to hold regulatory capital
against all the underlying exposures associated with some or all the
bank's other securitizations as if the exposures had not been
securitized, and to deduct from tier 1 capital any after-tax gain-on-
sale resulting from such securitizations.
---------------------------------------------------------------------------
\73\ Interagency Guidance on Implicit Recourse in Asset
Securitizations, May 23, 2002.
---------------------------------------------------------------------------
Operational requirements for traditional securitizations. In a
traditional securitization, an originating bank typically transfers a
portion of the credit risk of exposures to third parties by selling
them to an SPE. Banks engaging in a traditional securitization may
exclude the underlying exposures from the calculation of risk-weighted
assets only if each of the following conditions is met: (i) The
transfer is a sale under GAAP; (ii) the originating bank transfers to
third parties credit risk associated with the underlying exposures; and
(iii) any clean-up calls relating to the securitization are eligible
clean-up calls (as discussed below).
Originating banks that meet these conditions must hold regulatory
capital against any securitization exposures they retain in connection
with the securitization. Originating banks that fail to meet these
conditions must hold regulatory capital against the transferred
exposures as if they had not been securitized and must deduct from tier
1 capital any gain-on-sale resulting from the transaction.
Clean-up calls. For purposes of these operational requirements, a
clean-up call is a contractual provision that permits a servicer to
call securitization exposures (for example, asset-backed securities)
before the stated (or contractual) maturity or call date. In the case
of a traditional securitization, a clean-up call is generally
accomplished by repurchasing the remaining securitization exposures
once the amount of underlying exposures or outstanding securitization
exposures has fallen below a specified level. In the case of a
synthetic securitization, the clean-up call may take the form of a
clause that extinguishes the credit protection once the amount of
underlying exposures has fallen below a specified level.
To satisfy the operational requirements for securitizations--and,
therefore, to enable an originating bank to exclude the underlying
exposures from the calculation of its risk-based capital requirements--
any clean-up call associated with a securitization must be an eligible
clean-up call. An eligible clean-up call is a clean-up call that:
(i) Is exercisable solely at the discretion of the servicer;
(ii) Is not structured to avoid allocating losses to securitization
exposures held by investors or otherwise structured to provide credit
enhancement to the securitization (for example, to purchase non-
performing underlying exposures); and
(iii) (A) For a traditional securitization, is only exercisable
when 10 percent or less of the principal amount of the underlying
exposures or securitization exposures (determined as of the inception
of the securitization) is outstanding.
(B) For a synthetic securitization, is only exercisable when 10
percent or less of the principal amount of the reference portfolio of
underlying exposures (determined as of the inception of the
securitization) is outstanding.
Over the last several years, the agencies have published a
significant amount of supervisory guidance to assist banks with
assessing the extent to which they have transferred credit risk and,
consequently, may recognize any reduction in required regulatory
capital as a result of a securitization or other
[[Page 55884]]
form of credit risk transfer.\74\ In general, the agencies would expect
banks to continue to use this guidance, most of which remains
applicable to the securitization framework. Banks are encouraged to
consult with their primary Federal supervisor about transactions that
require additional guidance.
---------------------------------------------------------------------------
\74\ See, e.g., OCC Bulletin 99-46 (Dec. 14, 1999) (OCC); FDIC
Financial Institution Letter 109-99 (Dec. 13, 1999) (FDIC); SR
Letter 99-37 (Dec. 13, 1999) (Board); CEO Ltr. 99-119 (Dec. 14,
1999) (OTS).
---------------------------------------------------------------------------
2. Ratings-Based Approach (RBA)
Under the RBA, a bank would determine the risk-weighted asset
amount for a securitization exposure that has an external rating or
inferred rating by multiplying the amount of the exposure by the
appropriate risk-weight provided in the tables in section 43 of the
proposed rule. An originating bank must use the RBA if its retained
securitization exposure has at least two external ratings or an
inferred rating based on at least two external ratings; an investing
bank must use the RBA if its securitization exposure has one or more
external or inferred ratings. For purposes of the proposed rule, an
originating bank means a bank that meets either of the following
conditions: (i) The bank directly or indirectly originated or
securitized the underlying exposures included in the securitization; or
(ii) the securitization is an ABCP program and the bank serves as a
sponsor of the ABCP program.
This two-rating requirement for originating banks is the only
material difference between the treatment of originating banks and
investing banks under the securitization framework. Although this two-
rating requirement is not included in the New Accord, it is generally
consistent with the treatment of originating and investing banks in the
general risk-based capital rules. The agencies believe that the market
discipline evidenced by a third party purchasing a securitization
exposure obviates the need for a second rating for an investing bank.
Question 45: The agencies seek comment on this differential treatment
of originating banks and investing banks and on alternative mechanisms
that could be employed to ensure the reliability of external and
inferred ratings of non-traded securitization exposures retained by
originating banks.
Under the proposed rule, a bank also must use the RBA for
securitization exposures with an inferred rating. Similar to the
general risk-based capital rules, an unrated securitization exposure
would have an inferred rating if another securitization exposure
associated with the securitization transaction (that is, issued by the
same issuer and backed by the same underlying exposures) has an
external rating and the rated securitization exposure (i) is
subordinated in all respects to the unrated securitization exposure;
(ii) does not benefit from any credit enhancement that is not available
to the unrated securitization exposure; and (iii) has an effective
remaining maturity that is equal to or longer than the unrated
securitization exposure. Under the RBA, securitization exposures with
an inferred rating are treated the same as securitization exposures
with an identical external rating. Question 46: The agencies seek
comment on whether they should consider other bases for inferring a
rating for an unrated securitization position, such as using an
applicable credit rating on outstanding long-term debt of the issuer or
guarantor of the securitization exposure.
Under the RBA, the risk-based capital requirement per dollar of
securitization exposure would depend on four factors: (i) The
applicable rating of the exposure; (ii) whether the rating reflects a
long-term or short-term assessment of the exposure's credit risk; (iii)
whether the exposure is a ``senior'' exposure; and (iv) a measure of
the effective number (``N'') of underlying exposures. For a
securitization exposure with only one external or inferred rating, the
applicable rating of the exposure is that external or inferred rating.
For a securitization exposure with more than one external or inferred
rating, the applicable rating of the exposure is the lowest external or
inferred rating assigned to the exposure.
A ``senior securitization exposure'' is a securitization exposure
that has a first priority claim on the cash flows from the underlying
exposures, disregarding the claims of a service provider (such as a
swap counterparty or trustee, custodian, or paying agent for a
securitization) to fees from the securitization. A liquidity facility
that supports an ABCP program is a senior securitization exposure if
the liquidity facility provider's right to reimbursement of the drawn
amounts is senior to all claims on the cash flow from the underlying
exposures except claims of a service provider to fees. Question 47: The
agencies seek comment on the appropriateness of basing the risk-based
capital requirement for a securitization exposure under the RBA on the
seniority level of the exposure.
Under the RBA, a bank must use Table G below when the
securitization exposure's external rating represents a long-term credit
rating or its inferred rating is based on a long-term credit rating. A
bank must apply the risk weights in column 1 of Table G to the
securitization exposure if the effective number of underlying exposures
(N) is 6 or more and the securitization exposure is a senior
securitization exposure. If the notional number of underlying exposures
of a securitization is 25 or more or if all the underlying exposures
are retail exposures, a bank may assume that N is 6 or more (unless the
bank knows or has reason to know that N is less than 6). If the
notional number of underlying exposures of a securitization is less
than 25 and one or more of the underlying exposures is a non-retail
exposure, the bank must compute N as described in the SFA section
below. If N is 6 or more but the securitization exposure is not a
senior securitization exposure, the bank must apply the risk weights in
column 2 of Table G. A bank must apply the risk weights in column 3 of
Table G to the securitization exposure if N is less than 6. Question
48: The agencies seek comment on how well this approach captures the
most important risk factors for securitization exposures of varying
degrees of seniority and granularity.
[[Page 55885]]
Table G.--Long-Term Credit Rating Risk Weights Under RBA and IAA
----------------------------------------------------------------------------------------------------------------
Column 1 Column 2 Column 3
--------------------------------------------------------
Risk weights for Risk weights for
senior non-senior Risk weights for
Applicable rating (illustrative rating example) securitization securitization securitization
exposures backed exposures backed exposures backed
by granular pools by granular pools by non-granular
(percent) (percent) pools (percent)
----------------------------------------------------------------------------------------------------------------
Highest investment grade (for example, AAA)............ 7 12 20
Second highest investment grade (for example, AA)...... 8 15 25
Third-highest investment grade--positive designation 10 18 35
(for example, A+).....................................
Third-highest investment grade (for example, A)........ 12 20 .................
Third-highest investment grade--negative designation 20 35 .................
(for example, A-).....................................
----------------------------------------------------------------------------------------------------------------
Lowest investment grade--positive designation (for 35 50
example, BBB+)........................................
----------------------------------------------------------------------------------------------------------------
Lowest investment grade (for example, BBB)............. 60 75
----------------------------------------------------------------------------------------------------------------
Lowest investment grade--negative designation (for
example, BBB-)........................................ 100
----------------------------------------------------------------------------------------------------------------
One category below investment grade--positive
designation (for example, BB+)........................ 250
----------------------------------------------------------------------------------------------------------------
One category below investment grade (for example, BB).. 425
----------------------------------------------------------------------------------------------------------------
One category below investment grade--negative
designation (for example, BB-)........................ 650
----------------------------------------------------------------------------------------------------------------
More than one category below investment grade.......... Deduction from tier 1 and tier 2 capital.
----------------------------------------------------------------------------------------------------------------
A bank must apply the risk weights in Table H when the
securitization exposure's external rating represents a short-term
credit rating or its inferred rating is based on a short-term credit
rating. A bank must apply the decision rules outlined in the previous
paragraph to determine which column of Table H applies.
Table H.--Short-Term Credit Rating Risk Weights Under RBA and IAA
----------------------------------------------------------------------------------------------------------------
Column 1 Column 2 Column 3
--------------------------------------------------------
Risk weights for Risk weights for
senior non-senior Risk weights for
Applicable rating (illustrative rating example) securitization securitization securitization
exposures backed exposures backed exposures backed
by granular pools by granular pools by non-granular
(percent) (percent) pools (percent)
----------------------------------------------------------------------------------------------------------------
Highest investment grade (for example, A1)............. 7 12 20
Second highest investment grade (for example, A2)...... 12 20 35
Third highest investment grade (for example, A3)....... 60 75 75
All other ratings...................................... Deduction from tier 1 and tier 2 capital.
----------------------------------------------------------------------------------------------------------------
Within tables G and H, risk weights increase as rating grades
decline. Under column 2 of Table G, for example, the risk weights range
from 12 percent for exposures with the highest investment grade rating
to 650 percent for exposures rated one category below investment grade
with a negative designation. This pattern of risk weights is broadly
consistent with analyses employing standard credit risk models and a
range of assumptions regarding correlation effects and the types of
exposures being securitized.\75\ These analyses imply that, compared
with a corporate bond having a given level of stand-alone credit risk
(for example, as measured by its expected loss rate), a securitization
tranche having the same level of stand-alone credit risk--but backed by
a reasonably granular and diversified pool--will tend to exhibit more
systematic risk.\76\ This effect is most pronounced for below-
investment-grade tranches and is the primary reason why the RBA risk-
weights increase rapidly as ratings deteriorate over this range--much
more rapidly than for similarly rated corporate bonds.
---------------------------------------------------------------------------
\75\ See Vladislav Peretyatkin and William Perraudin, ``Capital
for Asset-Backed Securities,'' Bank of England, February 2003.
\76\ See, e.g., Michael Pykhtin and Ashish Dev, ``Credit Risk in
Asset Securitizations: An Analytical Model,'' Risk (May 2002) S16-
S20.
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Under the RBA, a securitization exposure that has an investment
grade rating and has fewer than six effective underlying exposures
generally receives a higher risk weight than a similarly rated
securitization exposure with six or more effective underlying
exposures. The agencies have designed the risk weights in this manner
to discourage a bank from engaging in regulatory capital arbitrage by
securitizing very high-quality wholesale exposures (that is, wholesale
exposures with a low PD and LGD), obtaining external ratings on the
securitization exposures issued by the securitization, and retaining
essentially all the credit risk of the pool of underlying exposures.
Consistent with the ANPR, the proposed rule requires a bank to
deduct from regulatory capital any securitization exposure with an
external or inferred rating below one category below investment grade
for long-term ratings or below investment grade for short-term ratings.
Several commenters
[[Page 55886]]
argued that this deduction is excessive in light of the credit risk of
such exposures. Although this proposed capital treatment is more
conservative than suggested by credit risk modeling analyses, the
agencies have decided to retain the deduction approach for low-non-
investment grade exposures. The agencies believe that there are
significant modeling uncertainties for such low-rated securitization
tranches. Moreover, external ratings of these tranches are subject to
less market discipline because these positions generally are retained
by the bank.
The proposed RBA differs in several important respects from the RBA
in the ANPR. First, under the ANPR, an originating bank (but not an
investing bank) would have to deduct from regulatory capital the amount
of any securitization exposure below the risk-based capital requirement
for the underlying exposures as if they were held directly by the bank,
regardless of whether the exposure would have qualified for a lower
risk-based capital requirement under the RBA. The agencies took this
position in the ANPR, in part, to provide incentives for originating
banks to shed deeply subordinated, high risk, difficult-to-value
securitization exposures. The agencies also were concerned that an
external credit rating may be less reliable when the rating applies to
a retained, non-traded exposure and is sought by an originating bank
primarily for regulatory capital purposes. Numerous commenters
criticized this aspect of the ANPR as lacking risk sensitivity and
inconsistently treating originating and investing banks. After further
review, the agencies have concluded that the risk sensitivity and logic
of the securitization framework would be enhanced by permitting
originating banks and investing banks to use the RBA on generally equal
terms. The agencies have revised the RBA to permit originating banks to
use the RBA even if the retained securitization exposure is below the
risk-based capital requirement for the underlying exposures as if they
were held directly by the bank.
In addition, the agencies have enhanced the risk sensitivity of the
RBA in the ANPR by introducing more risk-weight gradations for
securitization exposures with a long-term external or inferred rating
in the third-highest investment grade rating category. Although the
ANPR RBA applied the same risk weight to all securitization exposures
with long-term external ratings in the third-highest investment grade
rating category, the proposed rule provides three different risk
weights to securitization exposures that have long-term external
ratings in the third-highest investment grade rating category depending
on whether the rating has positive, negative, or no designation.
The agencies also have modified the ANPR RBA to expand the set of
lower risk-weights applicable to the most senior tranches of reasonably
granular securitizations to better reflect the low systematic risk of
such tranches. For example, under the ANPR, certain relatively senior
tranches of reasonably granular securitizations with long-term external
ratings in the two highest investment grade rating categories received
a lower risk-weight than more subordinated tranches of the same
securitizations. Under the proposed rule, the most senior tranches of
reasonably granular securitizations with long-term investment grade
external ratings receive a more favorable risk-weight as compared to
more subordinated tranches of the same securitizations. In addition, in
response to comments, the agencies have reduced the granularity
requirement for a senior securitization exposure to qualify for the
lower risk weights. Under the ANPR RBA, only securitization exposures
to a securitization that has an N of 100 or more could qualify for the
lower risk-weights. Under the proposed rule, securitization exposures
to a securitization that has an N of 6 or more would qualify for the
lower risk weights.
Although the proposed rule's RBA expands the availability of the
lower risk weights for senior securitization exposures in several
respects, it also has a more conservative but simpler definition of a
senior securitization exposure. The ANPR RBA imposed a mathematical
test for determining the relative seniority of a securitization
tranche. This test allowed the designation of multiple senior
securitization tranches for a particular securitization. By contrast,
the proposed RBA designates the most senior securitization tranche in a
particular securitization as the only securitization tranche eligible
for the lower risk weights.
In addition, some commenters argued that the ANPR RBA risk weights
for highly-rated senior retail securitization exposures were excessive
in light of the credit risk associated with such exposures. The
agencies have determined that empirical research on this point
(including that provided by commenters) is inconclusive and does not
warrant a reduction in the RBA risk weights of these exposures.
3. Internal Assessment Approach (IAA)
The proposed rule permits a bank to compute its risk-based capital
requirement for a securitization exposure to an ABCP program (such as a
liquidity facility or credit enhancement) using the bank's internal
assessment of the credit quality of the securitization exposure. To do
so, the bank's internal assessment process and the ABCP program must
meet certain qualification requirements in section 44 of the proposed
rule, and the securitization exposure must initially be internally
rated at least equivalent to investment grade. A bank that elects to
use the IAA for any securitization exposure to an ABCP program must use
the IAA to compute risk-based capital requirements for all
securitization exposures that qualify for the IAA approach. Under the
IAA, a bank would map its internal credit assessment of a
securitization exposure to an equivalent external credit rating from an
NRSRO. The bank would determine the risk-weighted asset amount for a
securitization exposure by multiplying the amount of the exposure
(using the methodology set forth above in the RBA section) by the
appropriate risk weight provided in Table G or H above.
The agencies included the IAA for securitization exposures to ABCP
programs in response to comments on the ANPR. The ANPR indicated that
the agencies expected banks to use the SFA or a ``Look-Through
Approach'' to determine risk-based capital requirements for exposures
to ABCP programs. Under the Look-Through Approach, a bank would
determine its risk-based capital requirement for an eligible liquidity
facility provided to an ABCP program by multiplying (i) 8 percent; (ii)
the maximum potential drawdown on the facility; (iii) an applicable
conversion factor of between 50 and 100 percent; and (iv) the
applicable risk weight (which would typically be 100 percent).
Commenters expressed concern that ABCP program sponsors would not have
sufficient data about the underlying exposures in the ABCP program to
use the SFA and that the Look-Through Approach produced economically
unreasonable capital requirements for these historically safe credit
exposures. The agencies are proposing to replace the Look-Through
Approach with the IAA, which is similar to an approach already
available to qualifying banks under the general risk-based capital
rules for credit enhancements to ABCP programs and which the agencies
believe would provide a more risk-sensitive and economically
appropriate risk-based
[[Page 55887]]
capital treatment for bank exposures to ABCP programs.
To use the IAA, a bank must receive prior written approval from its
primary Federal supervisor. To receive such approval, the bank would
have to demonstrate that its internal credit assessment process
satisfies all the following criteria. The bank's internal credit
assessments of securitization exposures to ABCP programs must be based
on publicly available rating criteria used by an NRSRO for evaluating
the credit risk of the underlying exposures. The bank's internal credit
assessments of securitization exposures used for regulatory capital
purposes must be consistent with those used in the bank's internal risk
management process, capital adequacy assessment process, and management
information reporting systems.
In addition, the bank's internal credit assessment process must
have sufficient granularity to identify gradations of risk. Each of the
bank's internal credit assessment categories must correspond to an
external credit rating of an NRSRO. The proposed rule also requires
that the bank's internal credit assessment process, particularly the
stress test factors for determining credit enhancement requirements, be
at least as conservative as the most conservative of the publicly
available rating criteria of the NRSROs that have provided external
credit ratings to the commercial paper issued by the ABCP program.
Moreover, the bank must have an effective system of controls and
oversight that ensures compliance with these operational requirements
and maintains the integrity of the internal credit assessments. The
bank must review and update each internal credit assessment whenever
new material information is available, but no less frequently than
annually. The bank must also validate its internal credit assessment
process on an ongoing basis, but not less frequently than annually.
To use the IAA on a specific exposure to an ABCP program, the
program must exhibit the following characteristics:
(i) All the commercial paper issued by the ABCP program must have
an external rating.
(ii) The ABCP program must have robust credit and investment
guidelines (that is, underwriting standards).
(iii) The ABCP program must perform a detailed credit analysis of
the asset sellers' risk profiles.
(iv) The ABCP program's underwriting policy must establish minimum
asset eligibility criteria that include a prohibition of the purchase
of assets that are significantly past due or defaulted, as well as
limitations on concentrations to an individual obligor or geographic
area and the tenor of the assets to be purchased.
(v) The aggregate estimate of loss on an asset pool that the ABCP
program is considering purchasing must consider all sources of
potential risk, such as credit and dilution risk.
(vi) The ABCP program must incorporate structural features into
each purchase of assets to mitigate potential credit deterioration of
the underlying exposures. Such features may include wind-down triggers
specific to a pool of underlying exposures.
4. Supervisory Formula Approach (SFA)
General requirements. Under the SFA, a bank would determine the
risk-weighted asset amount for a securitization exposure by multiplying
the SFA risk-based capital requirement for the exposure (as determined
by the supervisory formula set forth below) by 12.5. If the SFA risk
weight for a securitization exposure is 1,250 percent or greater,
however, the bank must deduct the exposure from total capital rather
than risk weight the exposure. Deduction is consistent with the
treatment of other high-risk securitization exposures, such as CEIOs.
The SFA capital requirement for a securitization exposure depends
on the following seven inputs:
(i) The amount of the underlying exposures (UE);
(ii) The securitization exposure's proportion of the tranche in
which it resides (TP);
(iii) The sum of the risk-based capital requirement and ECL for the
underlying exposures as if they were held directly on the bank's
balance sheet divided by the amount of the underlying exposures
(KIRB);
(iv) The tranche's credit enhancement level (L);
(v) The tranche's thickness (T);
(vi) The securitization's effective number of underlying exposures
(N); and
(vii) The securitization's exposure-weighted average loss given
default (EWALGD).
A bank may only use the SFA to determine its risk-based capital
requirement for a securitization exposure if the bank can calculate
each of these seven inputs on an ongoing basis. In particular, if a
bank cannot compute KIRB because the bank cannot compute the
risk-based capital requirement for all underlying exposures, the bank
may not use the SFA to compute its risk-based capital requirement for
the securitization exposure. In those cases, the bank would deduct the
exposure from regulatory capital.
The SFA capital requirement for a securitization exposure is UE
multiplied by TP multiplied by the greater of (i) 0.0056 * T; or (ii)
S[L+T]-S[L], where:
[GRAPHIC] [TIFF OMITTED] TP25SE06.041
[GRAPHIC] [TIFF OMITTED] TP25SE06.042
[GRAPHIC] [TIFF OMITTED] TP25SE06.043
[GRAPHIC] [TIFF OMITTED] TP25SE06.044
[[Page 55888]]
[GRAPHIC] [TIFF OMITTED] TP25SE06.045
[GRAPHIC] [TIFF OMITTED] TP25SE06.046
[GRAPHIC] [TIFF OMITTED] TP25SE06.047
[GRAPHIC] [TIFF OMITTED] TP25SE06.048
[GRAPHIC] [TIFF OMITTED] TP25SE06.049
[GRAPHIC] [TIFF OMITTED] TP25SE06.050
In these expressions, [beta][Y; a, b] refers to the cumulative beta
distribution with parameters a and b evaluated at Y. In the case where
N=1 and EWALGD=100 percent, S[Y] in formula (1) must be calculated with
K[Y] set equal to the product of KIRB and Y, and d set equal
to 1-KIRB. The major inputs to the SFA formula (UE, TP,
KIRB, L, T, EWALGD, and N) are defined below and in section
45 of the proposed rule.
The SFA formula effectively imposes a 56 basis point minimum risk-
based capital requirement (8 percent of the 7 percent risk weight) per
dollar of securitization exposure. A number of commenters on the ANPR
contended that this floor capital requirement in the SFA would be
excessive for many senior securitization exposures. Although such a
floor may impose a capital requirement that is too high for some
securitization exposures, the agencies continue to believe that some
minimum prudential capital requirement is appropriate in the
securitization context. This 7 percent risk-weight floor is also
consistent with the lowest capital requirement available under the RBA
and, thus, should reduce incentives for regulatory capital arbitrage.
The SFA formula is a blend of credit risk modeling results and
supervisory judgment. The function S[Y] incorporates two distinct
features. First, a pure model-based estimate of the pool's aggregate
systematic or non-diversifiable credit risk that is attributable to a
first loss position covering losses up to and including Y. Because the
tranche of interest covers losses over a specified range (defined in
terms of L and T), the tranche's systematic risk can be represented as
S[L+T] - S[L]. The second feature involves a supervisory add-on
primarily intended to avoid behavioral distortions associated with what
would otherwise be a discontinuity in capital requirements for
relatively thin mezzanine tranches lying just below and just above the
KIRB boundary: all tranches at or below KIRB
would be deducted from capital, whereas a very thin tranche just above
KIRB would incur a pure model-based percentage capital
requirement that could vary between zero and one, depending on the
number of effective underlying exposures (N). The supervisory add-on
applies primarily to positions just above KIRB, and its
quantitative effect diminishes rapidly as the distance from
KIRB widens.
Under the SFA, a bank must deduct from regulatory capital any
securitization exposures (or parts thereof) that absorb losses at or
below the level of KIRB. However, the specific
securitization exposures that are subject to this deduction treatment
under the SFA may change over time in response to variation in the
credit quality of the pool of underlying exposures. For example, if the
pool's IRB capital requirement were to increase after the inception of
a securitization, additional portions of unrated securitization
exposures may fall below KIRB and thus become subject to
deduction under the SFA. Therefore, if a bank owns an unrated first-
loss securitization exposure well in excess of KIRB, the
capital requirement on the exposure could climb rapidly in the event of
marked deterioration in the credit quality of the underlying exposures.
Apart from the risk-weight floor and other supervisory adjustments
described above, the supervisory formula attempts to be as consistent
as possible with the parameters and assumptions of the IRB framework
that would apply to the underlying exposures if held directly by a
bank.\77\ The specification of S[Y] assumes that KIRB is an
accurate measure of the total systematic credit risk of the pool of
underlying exposures and that a securitization merely redistributes
this systematic risk among its various tranches. In this way, S[Y]
embodies precisely the same asset correlations as are assumed elsewhere
within the IRB framework. In addition, this specification embodies the
result that a pool's systematic risk (that is, KIRB) tends
to be redistributed toward more senior tranches as the effective number
of underlying exposures in the pool (N) declines.\78\ The importance of
pool granularity depends on the pool's average loss severity rate,
EWALGD. For small values of N, the framework implies that, as EWALGD
increases, systematic risk is shifted toward senior tranches. For
highly granular pools, such as securitizations of retail exposures,
EWALGD would have no
[[Page 55889]]
influence on the SFA capital requirement.
---------------------------------------------------------------------------
\77\ The conceptual basis for specification of K[x] is developed
in Michael B. Gordy and David Jones, ``Random Tranches,'' Risk.
(Mar. 2003) 78-83.
\78\ See Michael Pykhtin and Ashish Dev, ``Coarse-grained
CDOs,'' Risk (Jan. 2003) 113-116.
---------------------------------------------------------------------------
Inputs to the SFA formula. The proposed rule provides the following
definitions of the seven inputs into the SFA formula.
(i) Amount of the underlying exposures (UE). This input (measured
in dollars) is the EAD of any underlying wholesale and retail exposures
plus the amount of any underlying exposures that are securitization
exposures (as defined in section 42(e) of the proposed rule) plus the
adjusted carrying value of any underlying equity exposures (as defined
in section 51(b) of the proposed rule). UE also would include any
funded spread accounts, cash collateral accounts, and other similar
funded credit enhancements.
(ii) Tranche percentage (TP). TP is the ratio of (i) the amount of
the bank's securitization exposure to (ii) the amount of the
securitization tranche that contains the bank's securitization
exposure.
(iii) KIRB. KIRB is the ratio of (i) the
risk-based capital requirement for the underlying exposures plus the
ECL of the underlying exposures (all as determined as if the underlying
exposures were directly held by the bank) to (ii) UE. The definition of
KIRB includes the ECL of the underlying exposures in the
numerator because if the bank held the underlying exposures on its
balance sheet, the bank also would hold reserves against the exposures.
The calculation of KIRB must reflect the effects of any
credit risk mitigant applied to the underlying exposures (either to an
individual underlying exposure, a group of underlying exposures, or to
the entire pool of underlying exposures). In addition, all assets
related to the securitization are to be treated as underlying exposures
for purposes of the SFA, including assets in a reserve account (such as
a cash collateral account).
(iv) Credit enhancement level (L). L is the ratio of (i) the amount
of all securitization exposures subordinated to the securitization
tranche that contains the bank's securitization exposure to (ii) UE.
Banks must determine L before considering the effects of any tranche-
specific credit enhancements (such as third-party guarantees that
benefit only a single tranche). Any after-tax gain-on-sale or CEIOs
associated with the securitization may not be included in L.
Any reserve account funded by accumulated cash flows from the
underlying exposures that is subordinated to the tranche that contains
the bank's securitization exposure may be included in the numerator and
denominator of L to the extent cash has accumulated in the account.
Unfunded reserve accounts (that is, reserve accounts that are to be
funded from future cash flows from the underlying exposures) may not be
included in the calculation of L.
In some cases, the purchase price of receivables will reflect a
discount that provides credit enhancement (for example, first loss
protection) for all or certain tranches. When this arises, L should be
calculated inclusive of this discount if the discount provides credit
enhancement for the securitization exposure.
(v) Thickness of tranche (T). T is the ratio of (i) the size of the
tranche that contains the bank's securitization exposure to (ii) UE.
(vi) Effective number of exposures (N). As a general matter, the
effective number of exposures would be calculated as follows:
[GRAPHIC] [TIFF OMITTED] TP25SE06.051
where EADi represents the EAD associated with the
ith instrument in the pool of underlying exposures. For
purposes of computing N, multiple exposures to one obligor must be
treated as a single underlying exposure. In the case of a re-
securitization (that is, a securitization in which some or all of the
underlying exposures are themselves securitization exposures), a bank
must treat each underlying securitization exposure as a single exposure
and must not look through to the exposures that secure the underlying
securitization exposures. The agencies recognize that this simple and
conservative approach to re-securitizations may result in the
differential treatment of economically similar securitization
exposures. Question 49: The agencies seek comment on suggested
alternative approaches for determining the N of a re-securitization.
N represents the granularity of a pool of underlying exposures
using an ``effective'' number of exposures concept rather than a
``gross'' number of exposures concept to appropriately assess the
diversification of pools that have individual underlying exposures of
different sizes. An approach that simply counts the gross number of
underlying exposures in a pool treats all exposures in the pool
equally. This simplifying assumption could radically overestimate the
granularity of a pool with numerous small exposures and one very large
exposure. The effective exposure approach captures the notion that the
risk profile of such an unbalanced pool is more like a pool of several
medium-sized exposures than like a pool of a large number of equally
sized small exposures.
For example, suppose Pool A contains four loans with EADs of $100
each. Under the formula set forth above, N for Pool A would be four,
precisely equal to the actual number of exposures. Suppose Pool B also
contains four loans: One loan with an EAD of $100 and three loans with
an EAD of $1. Although both pools contain four loans, Pool B is much
less diverse and granular than Pool A because Pool B is dominated by
the presence of a single $100 loan. Intuitively, therefore, N for Pool
B should be closer to one than to four. Under the formula in the rule,
N for Pool B is calculated as follows:
[GRAPHIC] [TIFF OMITTED] TP25SE06.052
(vii) Exposure-weighted average loss given default (EWALGD). The
EWALGD is calculated as:
[GRAPHIC] [TIFF OMITTED] TP25SE06.053
where LGDi represents the average LGD associated with all
exposures to the ith obligor. In the case of a re-
securitization, an LGD of 100 percent must be assumed for any
underlying exposure that is itself a securitization exposure.
Under certain conditions, a bank may employ the following
simplifications to the SFA. First, for securitizations all of whose
underlying exposures are retail exposures, a bank may set h = 0 and v =
0. In addition, if the share of a securitization corresponding to the
largest underlying exposure (C1) is no more than 0.03 (or 3
percent of the underlying exposures), then for purposes of the SFA the
bank may set EWALGD=0.50 and N equal to the following amount:
[[Page 55890]]
[GRAPHIC] [TIFF OMITTED] TP25SE06.054
where Cm is the ratio of (i) the sum of the amounts of the
largest `m' underlying exposures of the securitization; to (ii) UE. A
bank may select the level of `m' in its discretion. For example, if the
three largest underlying exposures of a securitization represent 15
percent of the pool of underlying exposures, C3 for the
securitization is 0.15. As an alternative simplification option, if
only C1 is available, and C1 is no more than
0.03, then the bank may set EWALGD=0.50 and N=1/C1.
5. Eligible Disruption Liquidity Facilities
The version of the SFA contained in the New Accord provides a more
favorable capital treatment for eligible disruption liquidity
facilities than for other securitization exposures. Under the New
Accord, an eligible disruption liquidity facility is a liquidity
facility that supports an ABCP program and that (i) is subject to an
asset quality test that precludes funding of underlying exposures that
are in default; (ii) can be used to fund only those exposures that have
an investment grade external rating at the time of funding, if the
underlying exposures that the facility must fund against are externally
rated exposures at the time that the exposures are sold to the program;
and (iii) may only be drawn in the event of a general market
disruption. Under the New Accord, a bank that uses the SFA to compute
its risk-based capital requirement for an eligible disruption liquidity
facility may multiply the facility's SFA-determined risk weight by 20
percent. Question 50: The agencies have not included this concept in
the proposed rule but seek comment on the prevalence of eligible
disruption liquidity facilities and a bank's expected use of the SFA to
calculate risk-based capital requirements for such facilities.
6. Credit Risk Mitigation for Securitization Exposures
An originating bank that has obtained a credit risk mitigant to
hedge its securitization exposure to a synthetic or traditional
securitization that satisfies the operational criteria in section 41 of
the proposed rule may recognize the credit risk mitigant, but only as
provided in section 46 of the proposed rule. An investing bank that has
obtained a credit risk mitigant to hedge a securitization exposure also
may recognize the credit risk mitigant, but only as provided in section
46. A bank that has used the RBA or IAA to calculate its risk-based
capital requirement for a securitization exposure whose external or
inferred rating (or equivalent internal rating under the IAA) reflects
the benefits of a particular credit risk mitigant provided to the
associated securitization or that supports some or all of the
underlying exposures, however, may not use the securitization credit
risk mitigation rules to further reduce its risk-based capital
requirement for the exposure based on that credit risk mitigant. For
example, a bank that owns a AAA-rated asset-backed security that
benefits, along with all the other securities issued by the
securitization SPE, from an insurance wrap that is part of the
securitization transaction would calculate its risk-based capital
requirement for the security strictly under the RBA; no additional
credit would be given for the presence of the insurance wrap. On the
other hand, if a bank owns a BBB-rated asset-backed security and
obtains a credit default swap from a AAA-rated counterparty to protect
the bank from losses on the security, the bank would be able to apply
the securitization CRM rules to recognize the risk mitigating effects
of the credit default swap and determine the risk-based capital
requirement for the position.
The proposed rule contains a separate treatment of CRM for
securitization exposures (versus wholesale and retail exposures)
because the wholesale and retail exposure CRM approaches rely on
substitutions of, or adjustments to, the risk parameters of the hedged
exposure. Because the securitization framework does not rely on risk
parameters to determine risk-based capital requirements for
securitization exposures, a different treatment of CRM for
securitization exposures is necessary.
The securitization CRM rules, like the wholesale and retail CRM
rules, address collateral separately from guarantees and credit
derivatives. A bank is not permitted to recognize collateral other than
financial collateral as a credit risk mitigant for securitization
exposures. A bank may recognize financial collateral in determining the
bank's risk-based capital requirement for a securitization exposure
using a collateral haircut approach. The bank's risk-based capital
requirement for a collateralized securitization exposure is equal to
the risk-based capital requirement for the securitization exposure as
calculated under the RBA or the SFA multiplied by the ratio of adjusted
exposure amount (E*) to original exposure amount (E), where:
(i) E* = max {0, [E - C x (1 - Hs - Hfx)]{time} ;
(ii) E = the amount of the securitization exposure (as calculated
under section 42(e) of the proposed rule);
(iii) C = the current market value of the collateral;
(iv) Hs = the haircut appropriate to the collateral type; and
(v) Hfx = the haircut appropriate for any currency mismatch between
the collateral and the exposure.
Where the collateral is a basket of different asset types or a basket
of assets denominated in different currencies, the haircut on the
basket will be
[GRAPHIC] [TIFF OMITTED] TP25SE06.055
where ai is the current market value of the asset in the
basket divided by the current market value of all assets in the basket
and Hi is the haircut applicable to that asset.
With the prior written approval of its primary Federal supervisor,
a bank may calculate haircuts using its own internal estimates of
market price volatility and foreign exchange volatility, subject to the
requirements for use of own-estimates haircuts contained in section 32
of the proposed rule. Banks that use own-estimates haircuts for
collateralized securitization exposures must assume a minimum holding
period (TM) for securitization exposures of 65 business
days.
A bank that does not qualify for and use own-estimates haircuts
must use the collateral type haircuts (Hs) in Table 3 of this preamble
and must use a currency mismatch haircut (Hfx) of 8 percent if the
exposure and the collateral are denominated in different currencies. To
reflect the longer-term nature of securitization exposures as compared
to eligible margin loans and OTC derivative contracts, however, these
standard supervisory haircuts (which are based on a 10-business-day
holding period and daily marking-to-
[[Page 55891]]
market and remargining) must be adjusted to a 65-business-day holding
period (the approximate number of business days in a calendar quarter)
by multiplying them by the square root of 6.5 (2.549510). A bank also
must adjust the standard supervisory haircuts upward on the basis of a
holding period longer than 65 business days where and as appropriate to
take into account the illiquidity of an instrument.
A bank may only recognize an eligible guarantee or eligible credit
derivative provided by an eligible securitization guarantor in
determining the bank's risk-based capital requirement for a
securitization exposure. Eligible guarantee and eligible credit
derivative are defined the same way as in the CRM rules for wholesale
and retail exposures. An eligible securitization guarantor is defined
to mean (i) a sovereign entity, the Bank for International Settlements,
the International Monetary Fund, the European Central Bank, the
European Commission, a Federal Home Loan Bank, the Federal Agricultural
Mortgage Corporation (Farmer Mac), a multi-lateral development bank, a
depository institution (as defined in section 3 of the Federal Deposit
Insurance Act (12 U.S.C. 1813)), a bank holding company (as defined in
section 2 of the Bank Holding Company Act (12 U.S.C. 1841)), a savings
and loan holding company (as defined in 12 U.S.C. 1467a) provided all
or substantially all of the holding company's activities are
permissible for a financial holding company under 12 U.S.C. 1843(k)), a
foreign bank (as defined in section 211.2 of the Federal Reserve
Board's Regulation K (12 CFR 211.2)), or a securities firm; (ii) any
other entity (other than an SPE) that has issued and outstanding an
unsecured long-term debt security without credit enhancement that has a
long-term applicable external rating in one of the three highest
investment grade rating categories; or (iii) any other entity (other
than an SPE) that has a PD assigned by the bank that is lower than or
equivalent to the PD associated with a long-term external rating in the
third-highest investment grade rating category.
A bank may recognize an eligible guarantee or eligible credit
derivative provided by an eligible securitization guarantor in
determining the bank's risk-based capital requirement for the
securitization exposure as follows. If the protection amount of the
eligible guarantee or eligible credit derivative equals or exceeds the
amount of the securitization exposure, then the bank may set the risk-
weighted asset amount for the securitization exposure equal to the
risk-weighted asset amount for a direct exposure to the eligible
securitization guarantor (as determined in the wholesale risk weight
function described in section 31 of the proposed rule), using the
bank's PD for the guarantor, the bank's ELGD and LGD for the guarantee
or credit derivative, and an EAD equal to the amount of the
securitization exposure (as determined in section 42(e) of the proposed
rule).
If, on the other hand, the protection amount of the eligible
guarantee or eligible credit derivative is less than the amount of the
securitization exposure, then the bank must divide the securitization
exposure into two exposures in order to recognize the guarantee or
credit derivative. The risk-weighted asset amount for the
securitization exposure is equal to the sum of the risk-weighted asset
amount for the covered portion and the risk-weighted asset amount for
the uncovered portion. The risk-weighted asset amount for the covered
portion is equal to the risk-weighted asset amount for a direct
exposure to the eligible securitization guarantor (as determined in the
wholesale risk weight function described in section 31 of the proposed
rule), using the bank's PD for the guarantor, the bank's ELGD and LGD
for the guarantee or credit derivative, and an EAD equal to the
protection amount of the credit risk mitigant. The risk-weighted asset
amount for the uncovered portion is equal to the product of (i) 1.0
minus (the protection amount of the eligible guarantee or eligible
credit derivative divided by the amount of the securitization
exposure); and (ii) the risk-weighted asset amount for the
securitization exposure without the credit risk mitigant (as determined
in sections 42-45 of the proposed rule).
For any hedged securitization exposure, the bank must make
applicable adjustments to the protection amount as required by the
maturity mismatch, currency mismatch, and lack of restructuring
provisions in paragraphs (d), (e), and (f) of section 33 of the
proposed rule. If the risk-weighted asset amount for a guaranteed
securitization exposure is greater than the risk-weighted asset amount
for the securitization exposure without the guarantee or credit
derivative, a bank may always elect not to recognize the guarantee or
credit derivative.
When a bank recognizes an eligible guarantee or eligible credit
derivative provided by an eligible securitization guarantor in
determining the bank's risk-based capital requirement for a
securitization exposure, the bank also must (i) calculate ECL for the
exposure using the same risk parameters that it uses for calculating
the risk-weighted asset amount of the exposure (that is, the PD
associated with the guarantor's rating grade, the ELGD and LGD of the
guarantee, and an EAD equal to the protection amount of the credit risk
mitigant); and (ii) add this ECL to the bank's total ECL.
7. Synthetic Securitizations
Background. In a synthetic securitization, an originating bank uses
credit derivatives or guarantees to transfer the credit risk, in whole
or in part, of one or more underlying exposures to third-party
protection providers. The credit derivative or guarantee may be either
collateralized or uncollateralized. In the typical synthetic
securitization, the underlying exposures remain on the balance sheet of
the originating bank, but a portion of the originating bank's credit
exposure is transferred to the protection provider or covered by
collateral pledged by the protection provider.
In general, the proposed rule's treatment of synthetic
securitizations is identical to that of traditional securitizations.
The operational requirements for synthetic securitizations are more
detailed than those for traditional securitizations and are intended to
ensure that the originating bank has truly transferred credit risk of
the underlying exposures to one or more third-party protection
providers.
Although synthetic securitizations typically employ credit
derivatives, which might suggest that such transactions would be
subject to the CRM rules in section 33 of the proposed rule, banks must
first apply the securitization framework when calculating risk-based
capital requirements for a synthetic securitization exposure. Banks may
ultimately be redirected to the securitization CRM rules to adjust the
securitization framework capital requirement for an exposure to reflect
the CRM technique used in the transaction.
Operational requirements for synthetic securitizations. For
synthetic securitizations, an originating bank may recognize for risk-
based capital purposes the use of CRM to hedge, or transfer credit risk
associated with, underlying exposures only if each of the following
conditions is satisfied:
(i) The credit risk mitigant is financial collateral, an eligible
credit derivative from an eligible securitization guarantor (defined
above), or an eligible guarantee from an eligible securitization
guarantor.
(ii) The bank transfers credit risk associated with the underlying
exposures to third-party investors, and
[[Page 55892]]
the terms and conditions in the credit risk mitigants employed do not
include provisions that:
(A) Allow for the termination of the credit protection due to
deterioration in the credit quality of the underlying exposures;
(B) Require the bank to alter or replace the underlying exposures
to improve the credit quality of the underlying exposures;
(C) Increase the bank's cost of credit protection in response to
deterioration in the credit quality of the underlying exposures;
(D) Increase the yield payable to parties other than the bank in
response to a deterioration in the credit quality of the underlying
exposures; or
(E) Provide for increases in a retained first loss position or
credit enhancement provided by the bank after the inception of the
securitization.
(iii) The bank obtains a well-reasoned opinion from legal counsel
that confirms the enforceability of the credit risk mitigant in all
relevant jurisdictions.
(iv) Any clean-up calls relating to the securitization are eligible
clean-up calls (as discussed above).
Failure to meet the above operational requirements for a synthetic
securitization would prevent the originating bank from using the
securitization framework and would require the originating bank to hold
risk-based capital against the underlying exposures as if they had not
been synthetically securitized. A bank that provides credit protection
to a synthetic securitization must use the securitization framework to
compute risk-based capital requirements for its exposures to the
synthetic securitization even if the originating bank failed to meet
one or more of the operational requirements for a synthetic
securitization.
Consistent with the treatment of traditional securitization
exposures, banks would be required to use the RBA for synthetic
securitization exposures that have an appropriate number of external or
inferred ratings. For an originating bank, the RBA would typically be
used only for the most senior tranche of the securitization, which
often would have an inferred rating. If a bank has a synthetic
securitization exposure that does not have an external or inferred
rating, the bank would apply the SFA to the exposure (if the bank and
the exposure qualify for use of the SFA) without considering any CRM
obtained as part of the synthetic securitization. Then, if the bank has
obtained a credit risk mitigant on the exposure as part of the
synthetic securitization, the bank would apply the securitization CRM
rules to reduce its risk-based capital requirement for the exposure.
For example, if the credit risk mitigant is financial collateral, the
bank must use the standard supervisory or own-estimates haircuts to
reduce its risk-based capital requirement. If the bank is a protection
provider to a synthetic securitization and has obtained a credit risk
mitigant on its exposure, the bank would also apply the securitization
CRM rules in section 46 of the proposed rule to reduce its risk-based
capital requirement on the exposure. If neither the RBA nor the SFA is
available, a bank would deduct the exposure from regulatory capital.
First-loss tranches. If a bank has a first-loss position in a pool
of underlying exposures in connection with a synthetic securitization,
the bank must deduct the position from regulatory capital unless (i)
the position qualified for use of the RBA or (ii) the bank and the
position qualified for use of the SFA and a portion of the position was
above KIRB.
Mezzanine tranches. In a typical synthetic securitization, an
originating bank obtains credit protection on a mezzanine, or second-
loss, tranche of a synthetic securitization by either (i) obtaining a
credit default swap or financial guarantee from a third-party financial
institution; or (ii) obtaining a credit default swap or financial
guarantee from an SPE whose obligations are secured by financial
collateral.
For a bank that creates a synthetic mezzanine tranche by obtaining
an eligible credit derivative or guarantee from an eligible
securitization guarantor, the bank generally would treat the notional
amount of the credit derivative or guarantee (as adjusted to reflect
any maturity mismatch, lack of restructuring coverage, or currency
mismatch) as a wholesale exposure to the protection provider and use
the IRB framework for wholesale exposures to determine the bank's risk-
based capital requirement for the exposure. A bank that creates the
synthetic mezzanine tranche by obtaining a guarantee or credit
derivative that is collateralized by financial collateral but provided
by a non-eligible securitization guarantor generally would (i) first
use the SFA to calculate the risk-based capital requirement on the
exposure (ignoring the guarantee or credit derivative and the
associated collateral); and (ii) then use the securitization CRM rules
to calculate any reductions to the risk-based capital requirement
resulting from the associated collateral. The bank may look only to the
protection provider from which it obtains the guarantee or credit
derivative when determining its risk-based capital requirement for the
exposure (that is, if the protection provider hedges the guarantee or
credit derivative with a guarantee or credit derivative from a third
party, the bank may not look through the protection provider to that
third party when calculating its risk-based capital requirement for the
exposure).
For a bank providing credit protection on a mezzanine tranche of a
synthetic securitization, the bank would use the RBA to determine the
risk-based capital requirement for the exposure if the exposure has an
external or inferred rating. If the exposure does not have an external
or inferred rating and the exposure qualifies for use of the SFA, the
bank would use the SFA to calculate the risk-based capital requirement
for the exposure. If neither the RBA nor the SFA are available, the
bank would deduct the exposure from regulatory capital. If a bank
providing credit protection on the mezzanine tranche of a synthetic
securitization obtains a credit risk mitigant to hedge its exposure,
the bank could apply the securitization CRM rules to reflect the risk
reduction achieved by the credit risk mitigant.
Super-senior tranches. A bank that has the most senior position in
a pool of underlying exposures in connection with a synthetic
securitization would use the RBA to calculate its risk-based capital
requirement for the exposure if the exposure has at least one external
or inferred rating (in the case of an investing bank) or at least two
external or inferred ratings (in the case of an originating bank). If
the super-senior tranche does not have an external or inferred rating
and the bank and the exposure qualify for use of the SFA, the bank
would use the SFA to calculate the risk-based capital requirement for
the exposure. If neither the RBA nor the SFA are available, the bank
would deduct the exposure from regulatory capital. If an investing bank
in the super-senior tranche of a synthetic securitization obtains a
credit risk mitigant to hedge its exposure, however, the investing bank
may apply the securitization CRM rules to reflect the risk reduction
achieved by the credit risk mitigant.
8. Nth To Default Credit Derivatives
Credit derivatives that provide credit protection only for the nth
defaulting reference exposure in a group of reference exposures (nth to
default credit derivatives) are similar to synthetic securitizations
that provide credit protection only after the first-loss
[[Page 55893]]
tranche has defaulted or become a loss. A simplified treatment is
available to banks that purchase and provide such credit protection. A
bank that obtains credit protection on a group of underlying exposures
through a first-to-default credit derivative must determine its risk-
based capital requirement for the underlying exposures as if the bank
had synthetically securitized only the underlying exposure with the
lowest capital requirement (K) (as calculated under Table 2 of the
proposed rule) and had obtained no credit risk mitigant on the other
(higher capital requirement) underlying exposures. If the bank
purchases credit protection on a group of underlying exposures through
an nth-to-default credit derivative (other than a first-to-default
credit derivative), it may only recognize the credit protection for
risk-based capital purposes either if it has obtained credit protection
on the same underlying exposures in the form of first-through-(n-1)-to-
default credit derivatives, or if n-1 of the underlying exposures have
already defaulted. In such a case, the bank would again determine its
risk-based capital requirement for the underlying exposures as if the
bank had only synthetically securitized the n-1 underlying exposures
with the lowest capital requirement (K) (as calculated under Table 2 of
the proposed rule) and had obtained no credit risk mitigant on the
other underlying exposures.
A bank that provides credit protection on a group of underlying
exposures through a first-to-default credit derivative must determine
its risk-weighted asset amount for the derivative by applying the RBA
(if the derivative qualifies for the RBA) or, if the derivative does
not qualify for the RBA, by setting its risk-weighted asset amount for
the derivative equal to the product of (i) the protection amount of the
derivative; (ii) 12.5; and (iii) the sum of the risk-based capital
requirements (K) of the individual underlying exposures (as calculated
under Table 2 of the proposed rule), up to a maximum of 100 percent. If
a bank provides credit protection on a group of underlying exposures
through an nth-to-default credit derivative (other than a first-to-
default credit derivative), the bank must determine its risk-weighted
asset amount for the derivative by applying the RBA (if the derivative
qualifies for the RBA) or, if the derivative does not qualify for the
RBA, by setting the risk-weighted asset amount for the derivative equal
to the product of (i) the protection amount of the derivative; (ii)
12.5; and (iii) the sum of the risk-based capital requirements (K) of
the individual underlying exposures (as calculated under Table 2 of the
proposed rule and excluding the n-1 underlying exposures with the
lowest risk-based capital requirements), up to a maximum of 100
percent.
For example, a bank provides credit protection in the form of a
second-to-default credit derivative on a basket of five reference
exposures. The derivative is unrated and the protection amount of the
derivative is $100. The risk-based capital requirements of the
underlying exposures are 2.5 percent, 5.0 percent, 10.0 percent, 15.0
percent, and 20 percent. The risk-weighted asset amount of the
derivative would be $100 x 12.5 x (.05 + .10 + .15 + .20) or $625. If
the derivative were externally rated in the lowest investment grade
rating category with a positive designation, the risk-weighted asset
amount would be $100 x 0.50 or $50.
9. Early Amortization Provisions
Background. Many securitizations of revolving credit facilities
(for example, credit card receivables) contain provisions that require
the securitization to be wound down and investors to be repaid if the
excess spread falls below a certain threshold.\79\ This decrease in
excess spread may, in some cases, be caused by deterioration in the
credit quality of the underlying exposures. An early amortization event
can increase a bank's capital needs if new draws on the revolving
credit facilities would need to be financed by the bank using on-
balance sheet sources of funding. The payment allocations used to
distribute principal and finance charge collections during the
amortization phase of these transactions also can expose a bank to
greater risk of loss than in other securitization transactions. To
address the risks that early amortization of a securitization poses to
originating banks, the agencies propose the capital treatment described
below.
---------------------------------------------------------------------------
\79\ The proposed rule defines excess spread for a period as
gross finance charge collections (including market interchange fees)
and other income received by the SPE over the period minus interest
paid to holders of securitization exposures, servicing fees, charge-
offs, and other senior trust similar expenses of the SPE over the
period, all divided by the principal balance of the underlying
exposures at the end of the period.
---------------------------------------------------------------------------
The proposed rule would define an early amortization provision as a
provision in a securitization's governing documentation that, when
triggered, causes investors in the securitization exposures to be
repaid before the original stated maturity of the securitization
exposure, unless the provision is solely triggered by events not
related to the performance of the underlying exposures or the
originating bank (such as material changes in tax laws or regulations).
Under the proposed rule, an originating bank must generally hold
regulatory capital against the sum of the originating bank's interest
and the investors' interest arising from a revolving securitization
that contains an early amortization provision. An originating bank must
compute its capital requirement for its interest using the hierarchy of
approaches for securitization exposures as described above. The
originating bank's risk-weighted asset amount with respect to the
investors' interest in the securitization is equal to the product of
the following four quantities: (i) The EAD associated with the
investors' interest; (ii) the appropriate conversion factor (CF) as
determined below; (iii) KIRB; and (iv) 12.5.
Under the proposed rule, as noted above, a bank is not required to
hold regulatory capital against the investors' interest if early
amortization is solely triggered by events not related to the
performance of the underlying exposures or the originating bank, such
as material changes in tax laws or regulation. Under the New Accord, a
bank is also not required to hold regulatory capital against the
investors' interest if (i) the securitization has a replenishment
structure in which the individual underlying exposures do not revolve
and the early amortization ends the ability of the originating bank to
add new underlying exposures to the securitization; (ii) the
securitization involves revolving assets and contains early
amortization features that mimic term structures (that is, where the
risk of the underlying exposures does not return to the originating
bank); or (iii) investors in the securitization remain fully exposed to
future draws by borrowers on the underlying exposures even after the
occurrence of early amortization. Question 51: The agencies seek
comment on the appropriateness of these additional exemptions in the
U.S. markets for revolving securitizations.
Under the proposed rule, the investors' interest with respect to a
revolving securitization captures both the drawn balances and undrawn
lines of the underlying exposures that are allocated to the investors
in the securitization. The EAD associated with the investors' interest
is equal to the EAD of the underlying exposures multiplied by the ratio
of the total amount of securitization exposures issued by the SPE to
investors; divided by the outstanding principal amount of underlying
exposures.
[[Page 55894]]
In general, the applicable CF would depend on whether the early
amortization provision repays investors through a ``controlled'' or
``non-controlled'' mechanism and whether the underlying exposures are
revolving retail credit facilities that are uncommitted--that is,
unconditionally cancelable by the bank to the fullest extent of Federal
law (for example, credit card receivables)--or are other revolving
credit facilities (for example, revolving corporate credit facilities).
Under the proposed rule, a ``controlled'' early amortization provision
meets each of the following conditions:
(i) The originating bank has appropriate policies and procedures to
ensure that it has sufficient capital and liquidity available in the
event of an early amortization;
(ii) Throughout the duration of the securitization (including the
early amortization period) there is the same pro rata sharing of
interest, principal, expenses, losses, fees, recoveries, and other cash
flows from the underlying exposures, based on the originating bank's
and the investors' relative shares of the underlying exposures
outstanding measured on a consistent monthly basis;
(iii) The amortization period is sufficient for at least 90 percent
of the total underlying exposures outstanding at the beginning of the
early amortization period to have been repaid or recognized as in
default; and
(iv) The schedule for repayment of investor principal is not more
rapid than would be allowed by straight-line amortization over an 18-
month period.
An early amortization provision that does not meet any of the above
criteria is a ``non-controlled'' early amortization provision. Question
52: The agencies solicit comment on the distinction between controlled
and non-controlled early amortization provisions and on the extent to
which banks use controlled early amortization provisions. The agencies
also invite comment on the proposed definition of a controlled early
amortization provision, including in particular the 18-month period set
forth above.
Controlled early amortization. To calculate the appropriate CF for
a securitization of uncommitted revolving retail exposures that
contains a controlled early amortization provision, a bank must compare
the three-month average excess spread for the securitization to the
point at which the bank is required to trap excess spread under the
securitization transaction. In securitizations that do not require
excess spread to be trapped, or that specify a trapping point based
primarily on performance measures other than the three-month average
excess spread, the excess spread trapping point is 4.5 percent. The
bank must divide the three-month average excess spread level by the
excess spread trapping point and apply the appropriate CF from Table I.
Question 53: The agencies seek comment on the appropriateness of the
4.5 percent excess spread trapping point and on other types and levels
of early amortization triggers used in securitizations of revolving
retail exposures that should be considered by the agencies.
Table I.--Controlled Early Amortization Provisions
------------------------------------------------------------------------
Uncommitted Committed
------------------------------------------------------------------------
Retail Credit Lines............ 3-month average excess 90% CF.
spread Conversion
Factor (CF).
133.33% of trapping
point or more
0% CF.................
less than 133.33% to
100% of trapping
point
1% CF.................
less than 100% to 75%
of trapping point
2% CF.................
less than 75% to 50%
of trapping point
10% CF................
less than 50% to 25%
of trapping point
20% CF................
less than 25% of
trapping point
40% CF................
Non-retail Credit Lines........ 90% CF................ 90% CF.
------------------------------------------------------------------------
A bank must apply a 90 percent CF for all other revolving
underlying exposures (that is, committed exposures and non-retail
exposures) in securitizations containing a controlled early
amortization provision. The CFs for uncommitted revolving retail credit
lines are much lower than for committed retail credit lines or for non-
retail credit lines because of the demonstrated ability of banks to
monitor and, when appropriate, to curtail promptly uncommitted retail
credit lines for customers of deteriorating credit quality. Such
account management tools are unavailable for committed lines, and banks
may be less proactive about using such tools in the case of uncommitted
non-retail credit lines owing to lender liability concerns and the
prominence of broad-based, longer-term customer relationships.
Question 54: The agencies seek comment on and supporting empirical
analysis of the appropriateness of a more simple alternative approach
that would impose at all times a flat CF on the entire investors'
interest of a revolving securitization with a controlled early
amortization provision, and on what an appropriate level of such a CF
would be (for example, 10 or 20 percent).
Noncontrolled early amortization. To calculate the appropriate CF
for securitizations of uncommitted revolving retail exposures that
contain a noncontrolled early amortization provision, a bank must
perform the excess spread calculations described in the controlled
early amortization section above and then apply the CFs in Table J.
Table J.--Non-Controlled Early Amortization Provisions
------------------------------------------------------------------------
Uncommitted Committed
------------------------------------------------------------------------
Retail Credit Lines............ 3-month average excess 100% CF.
spread Conversion
Factor (CF).
[[Page 55895]]
133.33% of trapping
point or more
0% CF.................
less than 133.33% to
100% of trapping
point
5% CF.................
less than 100% to 75%
of trapping point
15% CF................
less than 75% to 50%
of trapping point
50% CF................
less than 50% of
trapping point
100% CF...............
Non-retail Credit Lines........ 100% CF............... 100% CF.
------------------------------------------------------------------------
A bank must use a 100 percent CF for all other revolving underlying
exposures (that is, committed exposures and nonretail exposures) in
securitizations containing a noncontrolled early amortization
provision. In other words, no risk transference would be recognized for
these transactions; an originating bank's IRB capital requirement would
be the same as if the underlying exposures had not been securitized.
In circumstances where a securitization contains a mix of retail
and nonretail exposures or a mix of committed and uncommitted
exposures, a bank may take a pro rata approach to determining the risk-
based capital requirement for the securitization's early amortization
provision. If a pro rata approach is not feasible, a bank must treat
the securitization as a securitization of nonretail exposures if a
single underlying exposure is a nonretail exposure and must treat the
securitization as a securitization of committed exposures if a single
underlying exposure is a committed exposure.
F. Equity Exposures
1. Introduction and Exposure Measurement
This section describes the proposed rule's risk-based capital
treatment for equity exposures. Under the proposed rule, a bank would
have the option to use either a simple risk-weight approach (SRWA) or
an internal models approach (IMA) for equity exposures that are not
exposures to an investment fund. A bank would use a look-through
approach for equity exposures to an investment fund. Under the SRWA, a
bank would generally assign a 300 percent risk weight to publicly
traded equity exposures and a 400 percent risk weight to non-publicly
traded equity exposures. Certain equity exposures to sovereigns,
multilateral institutions, and public sector enterprises would have a
risk weight of 0 percent, 20 percent, or 100 percent; and certain
community development equity exposures, hedged equity exposures, and,
up to certain limits, non-significant equity exposures would receive a
100 percent risk weight.
Alternatively, a bank that meets certain minimum quantitative and
qualitative requirements on an ongoing basis and obtains the prior
written approval of its primary Federal supervisor could use the IMA to
determine its risk-based capital requirement for all modeled equity
exposures. A bank that qualifies to use the IMA may apply the IMA to
its publicly traded and non-publicly traded equity exposures, or may
choose to apply the IMA only to its publicly traded equity exposures.
However, if the bank applies the IMA to its publicly traded equity
exposures, it must apply the IMA to all such exposures. Similarly, if a
bank applies the IMA to both publicly traded and non-publicly traded
equity exposures, it must apply the IMA to all such exposures. If a
bank does not qualify to use the IMA, or elects not to use the IMA, to
compute its risk-based capital requirements for equity exposures, the
bank must apply the SRWA to assign risk weights to its equity
exposures.
The proposed rule defines a publicly traded equity exposure as an
equity exposure traded on (i) any exchange registered with the SEC as a
national securities exchange under section 6 of the Securities Exchange
Act of 1934 (15 U.S.C. 78f) or (ii) any non-U.S.-based securities
exchange that is registered with, or approved by, a national securities
regulatory authority, provided that there is a liquid, two-way market
for the exposure (that is, there are enough bona fide offers to buy and
sell so that a sales price reasonably related to the last sales price
or current bona fide competitive bid and offer quotations can be
determined promptly and a trade can be settled at such a price within
five business days). Question 55: The agencies seek comment on this
definition.
A bank using either the IMA or the SRWA must determine the adjusted
carrying value for each equity exposure. The proposed rule defines the
adjusted carrying value of an equity exposure as:
(i) For the on-balance sheet component of an equity exposure, the
bank's carrying value of the exposure reduced by any unrealized gains
on the exposure that are reflected in such carrying value but excluded
from the bank's tier 1 and tier 2 capital; \80\ and
---------------------------------------------------------------------------
\80\ The potential downward adjustment to the carrying value of
an equity exposure reflects the fact that 100 percent of the
unrealized gains on available-for-sale equity exposures are included
in carrying value but only up to 45 percent of any such unrealized
gains are included in regulatory capital.
---------------------------------------------------------------------------
(ii) For the off-balance sheet component of an equity exposure, the
effective notional principal amount of the exposure, the size of which
is equivalent to a hypothetical on-balance sheet position in the
underlying equity instrument that would evidence the same change in
fair value (measured in dollars) for a given small change in the price
of the underlying equity instrument, minus the adjusted carrying value
of the on-balance sheet component of the exposure as calculated in (i).
The agencies created the definition of the effective notional
principal amount of the off-balance sheet portion of an equity exposure
to provide a uniform method for banks to measure the on-balance sheet
equivalent of an off-balance sheet exposure. For example, if the value
of a derivative contract referencing the common stock of company X
changes the same amount as the value of 150 shares of common stock of
company X, for a small (for example, 1 percent) change in the value of
the common stock of company X, the effective notional principal amount
of the derivative contract is the current value of 150 shares of common
stock of company X regardless of the number of shares the derivative
contract
[[Page 55896]]
references. The adjusted carrying value of the off-balance sheet
component of the derivative is the current value of 150 shares of
common stock of company X minus the adjusted carrying value of any on-
balance sheet amount associated with the derivative. Question 56: The
agencies seek comment on the approach to adjusted carrying value for
the off-balance sheet component of equity exposures and on alternative
approaches that may better capture the market risk of such exposures.
Hedge transactions. For purposes of determining risk-weighted
assets under both the SRWA and the IMA, a bank may identify hedge
pairs, which the proposed rule defines as two equity exposures that
form an effective hedge so long as each equity exposure is publicly
traded or has a return that is primarily based on a publicly traded
equity exposure. A bank may risk weight only the effective and
ineffective portions of a hedge pair rather than the entire adjusted
carrying value of each exposure that makes up the pair. Two equity
exposures form an effective hedge if the exposures either have the same
remaining maturity or each has a remaining maturity of at least three
months; the hedge relationship is formally documented in a prospective
manner (that is, before the bank acquires at least one of the equity
exposures); the documentation specifies the measure of effectiveness
(E) the bank will use for the hedge relationship throughout the life of
the transaction; and the hedge relationship has an E greater than or
equal to 0.8. A bank must measure E at least quarterly and must use one
of three alternative measures of E--the dollar-offset method, the
variability-reduction method, or the regression method.
It is possible that only part of a bank's exposure to a particular
equity instrument would be part of a hedge pair. For example, assume a
bank has an equity exposure A with a $300 adjusted carrying value and
chooses to hedge a portion of that exposure with an equity exposure B
with an adjusted carrying value of $100. Also assume that the
combination of equity exposure B and $100 of the adjusted carrying
value of equity exposure A form an effective hedge with an E of 0.8. In
this situation the bank would treat $100 of equity exposure A and $100
of equity exposure B as a hedge pair, and the remaining $200 of its
equity exposure A as a separate, stand-alone position.
The effective portion of a hedge pair is E multiplied by the
greater of the adjusted carrying values of the equity exposures forming
a hedge pair, whereas the ineffective portion is (1-E) multiplied by
the greater of the adjusted carrying values of the equity exposures
forming a hedge pair. In the above example, the effective portion of
the hedge pair would be 0.8 x $100 = $80 and the ineffective portion of
the hedge pair would be (1 - 0.8) x $100 = $20.
Measures of hedge effectiveness. Under the dollar-offset method of
measuring effectiveness, the bank must determine the ratio of the
cumulative sum of the periodic changes in the value of one equity
exposure to the cumulative sum of the periodic changes in the value of
the other equity exposure, termed the ratio of value change (RVC). If
the changes in the values of the two exposures perfectly offset each
other, the RVC will be -1. If RVC is positive, implying that the values
of the two equity exposures moved in the same direction, the hedge is
not effective and E = 0. If RVC is negative and greater than or equal
to -1 (that is, between zero and -1), then E equals the absolute value
of RVC. If RVC is negative and less than -1, then E equals 2 plus RVC.
The variability-reduction method of measuring effectiveness
compares changes in the value of the combined position of the two
equity exposures in the hedge pair (labeled X) to changes in the value
of one exposure as though that one exposure were not hedged (labeled
A). This measure of E expresses the time-series variability in X as a
proportion of the variability of A. As the variability described by the
numerator becomes small relative to the variability described by the
denominator, the measure of effectiveness improves, but is bounded from
above by a value of 1. E can be computed as:
[GRAPHIC] [TIFF OMITTED] TP25SE06.057
Xt = At - Bt
A = the value at time t of the one exposure in a hedge pair, and
Bt = the value at time t of the other exposure in a
hedge pair.
The value of t will range from zero to T, where T is the length of
the observation period for the values of A and B, and is comprised of
shorter values each labeled t.
The regression method of measuring effectiveness is based on a
regression in which the change in value of one exposure in a hedge pair
is the dependent variable and the change in value of the other exposure
in a hedge pair is the independent variable. E equals the coefficient
of determination of this regression, which is the proportion of the
variation in the dependent variable explained by variation in the
independent variable. The closer the relationship between the values of
the two exposures, the higher E will be.
2. Simple Risk-Weight Approach (SRWA)
Under the SRWA in section 52 of the proposed rule, a bank would
determine the risk-weighted asset amount for each equity exposure,
other than an equity exposure to an investment fund, by multiplying the
adjusted carrying value of the equity exposure, or the effective
portion and ineffective portion of a hedge pair as described below, by
the lowest applicable risk weight in Table K. A bank would determine
the risk-weighted asset amount for an equity exposure to an investment
fund as set forth below (and in section 54 of the proposed rule). Use
of the SRWA would be most appropriate when a bank's equity holdings are
principally composed of non-traded instruments.
If a bank exclusively uses the SRWA for its equity exposures, the
bank's aggregate risk-weighted asset amount for its equity exposures
(other than equity exposures to investment funds) would be equal to the
sum of the risk-weighted asset amounts for each of the bank's
individual equity exposures.
Table K
------------------------------------------------------------------------
Risk weight Equity exposure
------------------------------------------------------------------------
0 Percent...................... An equity exposure to an entity whose
credit exposures are exempt from the
0.03 percent PD floor.
20 Percent...................... An equity exposure to a Federal Home
Loan Bank or Farmer Mac if the equity
exposure is not publicly traded and
is held as a condition of membership
in that entity.
100............................. Community development equity
exposures 81
Equity exposures to a Federal
Home Loan Bank or Farmer Mac not
subject to a 20 percent risk weight.
[[Page 55897]]
The effective portion of a
hedge pair.
Non-significant equity
exposures to the extent less than 10
percent of tier 1 plus tier 2
capital.
300 Percent..................... A publicly traded equity exposure
(including the ineffective portion of
a hedge pair).
400 Percent..................... An equity exposure that is not
publicly traded.
------------------------------------------------------------------------
Non-significant equity exposures. A bank may apply a 100 percent
risk weight to non-significant equity exposures, which the proposed
rule defines as equity exposures to the extent that the aggregate
adjusted carrying value of the exposures does not exceed 10 percent of
the bank's tier 1 capital plus tier 2 capital. To compute the aggregate
adjusted carrying value of a bank's equity exposures for determining
non-significance, the bank may exclude (i) equity exposures that
receive less than a 300 percent risk weight under the SRWA (other than
equity exposures determined to be non-significant), (ii) the equity
exposure in a hedge pair with the smaller adjusted carrying value, and
(iii) a proportion of each equity exposure to an investment fund equal
to the proportion of the assets of the investment fund that are not
equity exposures. If a bank does not know the actual holdings of the
investment fund, the bank may calculate the proportion of the assets of
the fund that are not equity exposures based on the terms of the
prospectus, partnership agreement, or similar contract that defines the
fund's permissible investments. If the sum of the investment limits for
all exposure classes\81\ within the fund exceeds 100 percent, the bank
must assume that the investment fund invests to the maximum extent
possible in equity exposures.
---------------------------------------------------------------------------
\81\ The proposed rule generally defines these exposures as
exposures that would qualify as community development investments
under 12 U.S.C. 24(Eleventh), excluding equity exposures to an
unconsolidated small business investment company and equity
exposures held through a consolidated small business investment
company described in section 302 of the Small Business Investment
Act of 1958 (15 U.S.C. 682). For savings associations, community
development investments would be defined to mean equity investments
that are designed primarily to promote community welfare, including
the welfare of low- and moderate-income communities or families,
such as by providing services or jobs, and excluding equity
exposures to an unconsolidated small business investment company and
equity exposures held through a consolidated small business
investment company described in section 302 of the Small Business
Investment Act of 1958 (15 U.S.C. 682).
---------------------------------------------------------------------------
When determining which of a bank's equity exposures qualify for a
100 percent risk weight based on non-significance, a bank must first
include equity exposures to unconsolidated small business investment
companies or held through consolidated small business investment
companies described in section 302 of the Small Business Investment Act
of 1958 (15 U.S.C. 682) and then must include publicly traded equity
exposures (including those held indirectly through investment funds)
and then must include non-publicly traded equity exposures (including
those held indirectly through investment funds).
3. Internal Models Approach (IMA)
The IMA is designed to provide banks with a more sophisticated and
risk-sensitive mechanism for calculating risk-based capital
requirements for equity exposures. To qualify to use the IMA, a bank
must receive prior written approval from its primary Federal
supervisor. To receive such approval, the bank must demonstrate to its
primary Federal supervisor's satisfaction that the bank meets the
following quantitative and qualitative criteria.
IMA qualification. First, the bank must have a model that (i)
assesses the potential decline in value of its modeled equity
exposures; (ii) is commensurate with the size, complexity, and
composition of the bank's modeled equity exposures; and (iii)
adequately captures both general market risk and idiosyncratic risks.
Second, the bank's model must produce an estimate of potential losses
for its modeled equity exposures that is no less than the estimate of
potential losses produced by a VaR methodology employing a 99.0 percent
one-tailed confidence interval of the distribution of quarterly returns
for a benchmark portfolio of equity exposures comparable to the bank's
modeled equity exposures using a long-term sample period.
In addition, the number of risk factors and exposures in the sample
and the data period used for quantification in the bank's model and
benchmarking exercise must be sufficient to provide confidence in the
accuracy and robustness of the bank's estimates. The bank's model and
benchmarking exercise also must incorporate data that are relevant in
representing the risk profile of the bank's modeled equity exposures,
and must include data from at least one equity market cycle containing
adverse market movements relevant to the risk profile of the bank's
modeled equity exposures. If the bank's model uses a scenario
methodology, the bank must demonstrate that the model produces a
conservative estimate of potential losses on the bank's modeled equity
exposures over a relevant long-term market cycle. If the bank employs
risk factor models, the bank must demonstrate through empirical
analysis the appropriateness of the risk factors used.
The agencies also would require that daily market prices be
available for all modeled equity exposures, either direct holdings or
proxies. Finally, the bank must be able to demonstrate, using
theoretical arguments and empirical evidence, that any proxies used in
the modeling process are comparable to the bank's modeled equity
exposures and that the bank has made appropriate adjustments for
differences. The bank must derive any proxies for its modeled equity
exposures or benchmark portfolio using historical market data that are
relevant to the bank's modeled equity exposures or benchmark portfolio
(or, where not, must use appropriately adjusted data), and such proxies
must be robust estimates of the risk of the bank's modeled equity
exposures.
In evaluating a bank's internal model for equity exposures, the
bank's primary Federal supervisor would consider, among other factors,
(i) the nature of the bank's equity exposures, including the number and
types of equity exposures (for example, publicly traded, non-publicly
traded, long, short); (ii) the risk characteristics and makeup of the
bank's equity exposures, including the extent to which publicly
available price information is obtainable on the exposures; and (iii)
the level and degree of concentration of, and correlations among, the
bank's equity exposures. Banks with equity portfolios containing equity
exposures with values that are highly nonlinear in nature (for example,
equity derivatives or convertibles) would have to employ an internal
model designed to appropriately capture the risks associated with these
instruments.
The agencies do not intend to dictate the form or operational
details of a bank's internal model for equity
[[Page 55898]]
exposures. Accordingly, the agencies would not prescribe any particular
type of model for determining risk-based capital requirements. Although
the proposed rule requires a bank that uses the IMA to ensure that its
internal model produces an estimate of potential losses for its modeled
equity exposures that is no less than the estimate of potential losses
produced by a VaR methodology employing a 99.0 percent one-tailed
confidence interval of the distribution of quarterly returns for a
benchmark portfolio of equity exposures, the proposed rule does not
require a bank to use a VaR-based model. The agencies recognize that
the type and sophistication of internal models will vary across banks
due to differences in the nature, scope, and complexity of business
lines in general and equity exposures in particular. The agencies
recognize that some banks employ models for internal risk management
and capital allocation purposes that can be more relevant to the bank's
equity exposures than some VaR models. For example, some banks employ
rigorous historical scenario analysis and other techniques for
assessing the risk of their equity portfolios.
Banks that choose to use a VaR-based internal model under the IMA
should use a historical observation period that includes a sufficient
amount of data points to ensure statistically reliable and robust loss
estimates relevant to the long-term risk profile of the bank's specific
holdings. The data used to represent return distributions should
reflect the longest sample period for which data are available and
should meaningfully represent the risk profile of the bank's specific
equity holdings. The data sample should be long-term in nature and, at
a minimum, should encompass at least one complete equity market cycle
containing adverse market movements relevant to the risk profile of the
bank's modeled exposures. The data used should be sufficient to provide
conservative, statistically reliable, and robust loss estimates that
are not based purely on subjective or judgmental considerations.
The parameters and assumptions used in a VaR model must be subject
to a rigorous and comprehensive regime of stress-testing. Banks
utilizing VaR models must subject their internal model and estimation
procedures, including volatility computations, to either hypothetical
or historical scenarios that reflect worst-case losses given underlying
positions in both publicly traded and non-publicly traded equities. At
a minimum, banks that use a VaR model must employ stress tests to
provide information about the effect of tail events beyond the level of
confidence assumed in the IMA.
Banks using non-VaR internal models that are based on stress tests
or scenario analyses would have to estimate losses under worst-case
modeled scenarios. These scenarios would have to reflect the
composition of the bank's equity portfolio and should produce risk-
based capital requirements at least as large as those that would be
required to be held against a representative market index or other
relevant benchmark portfolio under a VaR approach. For example, for a
portfolio consisting primarily of publicly held equity securities that
are actively traded, risk-based capital requirements produced using
historical scenario analyses should be greater than or equal to risk-
based capital requirements produced by a baseline VaR approach for a
major index or sub-index that is representative of the bank's holdings.
Similarly, non-publicly traded equity exposures may be benchmarked
against a representative portfolio of publicly traded equity exposures.
The loss estimate derived from the bank's internal model would
constitute the regulatory capital requirement for the modeled equity
exposures. The equity capital requirement would be incorporated into a
bank's risk-based capital ratio through the calculation of risk-
weighted equivalent assets. To convert the equity capital requirement
into risk-weighted equivalent assets, a bank would multiply the capital
requirement by 12.5.
Question 57: The agencies seek comment on the proposed rule's
requirements for IMA qualification, including in particular the
proposed rule's use of a 99.0 percent, quarterly returns standard.
Risk-weighted assets under the IMA. As noted above, a bank may
apply the IMA only to its publicly traded equity exposures or may apply
the IMA to its publicly traded and non-publicly traded equity
exposures. In either case, a bank is not allowed to apply the IMA to
equity exposures that receive a 0 or 20 percent risk weight under Table
9, community development equity exposures, equity exposures to a
Federal Home Loan Bank or Farmer Mac that receive a 100 percent risk
weight, and equity exposures to investment funds (collectively,
excluded equity exposures).
If a bank applies the IMA to both publicly traded and non-publicly
traded equity exposures, the bank's aggregate risk-weighted asset
amount for its equity exposures would be equal to the sum of the risk-
weighted asset amount of each excluded equity exposure (calculated
outside of the IMA section of the proposed rule) and the risk-weighted
asset amount of the non-excluded equity exposures (calculated under the
IMA section of the proposed rule). The risk-weighted asset amount of
the non-excluded equity exposures is generally set equal to the
estimate of potential losses on the bank's non-excluded equity
exposures generated by the bank's internal model multiplied by 12.5. To
ensure that a bank holds a minimum amount of risk-based capital against
its modeled equity exposures, however, the proposed rule contains a
supervisory floor on the risk-weighted asset amount of the non-excluded
equity exposures. As a result of this floor, the risk-weighted asset
amount of the non-excluded equity exposures could not fall below the
sum of (i) 200 percent multiplied by the aggregate adjusted carrying
value or ineffective portion of hedge pairs, as appropriate, of the
bank's non-excluded publicly traded equity exposures; and (ii) 300
percent multiplied by the aggregate adjusted carrying value of the
bank's non-excluded non-publicly traded equity exposures.
If, on the other hand, a bank applies the IMA only to its publicly
traded equity exposures, the bank's aggregate risk-weighted asset
amount for its equity exposures would be equal to the sum of (i) the
risk-weighted asset amount of each excluded equity exposure (calculated
outside of the IMA section of the proposed rule); (ii) 400 percent
multiplied by the aggregate adjusted carrying value of the bank's non-
excluded non-publicly traded equity exposures; and (iii) the aggregate
risk-weighted asset amount of its non-excluded publicly traded equity
exposures. The risk-weighted asset amount of the non-excluded publicly
traded equity exposures would be equal to the estimate of potential
losses on the bank's non-excluded publicly traded equity exposures
generated by the bank's internal model multiplied by 12.5. The risk-
weighted asset amount for the non-excluded publicly traded equity
exposures would be subject to a floor of 200 percent multiplied by the
aggregate adjusted carrying value or ineffective portion of hedge
pairs, as appropriate, of the bank's non-excluded publicly traded
equity exposures. Question 58: The agencies seek comment on the
operational aspects of these floor calculations.
4. Equity Exposures to Investment Funds
A bank must determine the risk-weighted asset amount for equity
exposures to investment funds using
[[Page 55899]]
one of three approaches: the Full Look-Through Approach, the Simple
Modified Look-Through Approach, or the Alternative Modified Look-
Through Approach, unless the equity exposure to an investment fund is a
community development equity exposure. Such equity exposures would be
subject to a 100 percent risk weight. If an equity exposure to an
investment fund is part of a hedge pair, a bank may use the ineffective
portion of a hedge pair as the adjusted carrying value for the equity
exposure to the investment fund. A bank may choose to apply a different
approach to different equity exposures to investment funds; the
proposed rule does not require a bank to apply the same approach to all
of its equity exposures to investment funds.
The proposed rule defines an investment fund as a company all or
substantially all of the assets of which are financial assets and which
has no material liabilities. The agencies have proposed a separate
treatment for equity exposures to an investment fund to prevent banks
from arbitraging the proposed rule's high risk-based capital
requirements for certain high-risk exposures and to ensure that banks
do not receive a punitive risk-based capital requirement for equity
exposures to investment funds that hold only low-risk assets. Question
59: The agencies seek comment on the necessity and appropriateness of
the separate treatment for equity exposures to investment funds and the
three approaches in the proposed rule. The agencies also seek comment
on the proposed definition of an investment fund.
Each of the approaches to equity exposures to investment funds
imposes a 7 percent minimum risk weight on equity exposures to
investment funds. This minimum risk weight is similar to the minimum 7
percent risk weight under the RBA for securitization exposures and the
effective 56 basis point minimum risk-based capital requirement per
dollar of securitization exposure under the SFA. The agencies believe
that this minimum prudential capital requirement is appropriate for
exposures not directly held by the bank.
Full look-through approach. A bank may use the full look-through
approach only if the bank is able to compute a risk-weighted asset
amount for each of the exposures held by the investment fund
(calculated under the proposed rule as if the exposures were held
directly by the bank). Under this approach, a bank would set the risk-
weighted asset amount of the bank's equity exposure to the investment
fund equal to the greater of (i) the product of (A) the aggregate risk-
weighted asset amounts of the exposures held by the fund as if they
were held directly by the bank and (B) the bank's proportional
ownership share of the fund; and (ii) 7 percent of the adjusted
carrying value of the bank's equity exposure to the investment fund.
Simple modified look-through approach. Under this approach, a bank
may set the risk-weighted asset amount for its equity exposure to an
investment fund equal to the adjusted carrying value of the equity
exposure multiplied by the highest risk weight in Table L that applies
to any exposure the fund is permitted to hold under its prospectus,
partnership agreement, or similar contract that defines the fund's
permissible investments. The bank may exclude derivative contracts that
are used for hedging, not speculative purposes, and do not constitute a
material portion of the fund's exposures. A bank may not assign an
equity exposure to an investment fund to an aggregate risk weight of
less than 7 percent under this approach.
Table L.-- Modified Look-Through Approaches for Equity Exposures to
Investment Funds
------------------------------------------------------------------------
Risk weight Exposure class
------------------------------------------------------------------------
0 percent....................... Sovereign exposures with a long-term
external rating in the highest
investment grade rating category and
sovereign exposures of the United
States.
20 percent...................... Exposures with a long-term external
rating in the highest or second-
highest investment grade rating
category; exposures with a short-term
external rating in the highest
investment grade rating category; and
exposures to, or guaranteed by,
depository institutions, foreign
banks (as defined in 12 CFR 211.2),
or securities firms subject to
consolidated supervision or
regulation comparable to that imposed
on U.S. securities broker-dealers
that are repo-style transactions or
bankers' acceptances.
50 percent...................... Exposures with a long-term external
rating in the third- highest
investment grade rating category or a
short-term external rating in the
second-highest investment grade
rating category.
100 percent..................... Exposures with a long-term or short-
term external rating in percent the
lowest investment grade rating
category.
200 percent..................... Exposures with a long-term external
rating one rating category percent
below investment grade.
300 percent..................... Publicly traded equity exposures.
400 percent..................... Non-publicly traded equity exposures;
exposures with a long-percent term
external rating two or more rating
categories below investment grade;
and unrated exposures (excluding
publicly traded equity exposures).
1,250 percent................... OTC derivative contracts and exposures
that must be deducted percent from
regulatory capital or receive a risk
weight greater than 400 percent under
this appendix.
------------------------------------------------------------------------
Alternative modified look-through approach. Under this approach, a
bank may assign the adjusted carrying value of an equity exposure to an
investment fund on a pro rata basis to different risk-weight categories
in Table L according to the investment limits in the fund's prospectus,
partnership agreement, or similar contract that defines the fund's
permissible investments. If the sum of the investment limits for all
exposure classes within the fund exceeds 100 percent, the bank must
assume that the fund invests to the maximum extent permitted under its
investment limits in the exposure class with the highest risk weight
under Table L, and continues to make investments in the order of the
exposure class with the next highest risk-weight under Table L until
the maximum total investment level is reached. If more than one
exposure class applies to an exposure, the bank must use the highest
applicable risk weight. A bank may exclude derivative contracts held by
the fund that are used for hedging, not speculative, purposes and do
not constitute a material portion of the fund's exposures. The overall
risk weight assigned to an equity exposure to an investment fund under
this approach may not be less than 7 percent.
VI. Operational Risk
This section describes features of the AMA framework for
determining the risk-based capital requirement for operational risk.
The proposed framework remains fundamentally similar to that described
in the ANPR. Under this framework, a bank meeting the AMA qualifying
criteria would use
[[Page 55900]]
its internal operational risk quantification system to calculate its
risk-based capital requirement for operational risk.
Currently, the agencies' general risk-based capital rules do not
include an explicit capital charge for operational risk. Rather, the
existing risk-based capital rules were designed to cover all risks, and
therefore implicitly cover operational risk. With the introduction of
the IRB framework for credit risk in this NPR, which would result in a
more risk-sensitive treatment of credit risk, there no longer would be
an implicit capital buffer for other risks.
The agencies recognize that operational risk is a key risk in
banks, and evidence indicates that a number of factors are driving
increases in operational risk. These factors include greater use of
automated technology, proliferation of new and highly complex products,
growth of e-banking transactions and related business applications,
large-scale acquisitions, mergers, and consolidations, and greater use
of outsourcing arrangements. Furthermore, the recent experience of a
number of high-profile, high-severity losses across the banking
industry, including those resulting from legal settlements, highlight
operational risk as a major source of unexpected losses. Because the
implicit regulatory capital buffer for operational risk would be
removed under the proposed rule, the agencies propose to require banks
using the IRB framework for credit risk to use the AMA to address
operational risk when computing a capital charge for regulatory capital
purposes.
As defined previously, operational risk exposure is the 99.9th
percentile of the distribution of potential aggregate operational
losses as generated by the bank's operational risk quantification
system over a one-year horizon. EOL is the expected value of the same
distribution of potential aggregate operational losses. The ANPR
specified that a bank's risk-based capital requirement for operational
risk would be the sum of EOL and UOL unless the bank could demonstrate
that an EOL offset would meet supervisory standards. The agencies
described two approaches--reserving and budgeting--that might allow for
some offset of EOL; however, the agencies expressed some reservation
about both approaches. The agencies believed that reserves established
for expected operational losses would likely not meet U.S. accounting
standards and that budgeted funds might not be sufficiently capital-
like to cover EOL.
While the proposed framework remains fundamentally similar to that
described in the ANPR and a bank would continue to be allowed to
recognize (i) certain offsets for EOL, and (ii) the effect of risk
mitigants such as insurance in calculating its regulatory capital
requirement for operational risk, the agencies have clarified certain
aspects of the proposed framework. In particular, the agencies have re-
assessed the ability of banks to take prudent steps to offset EOL
through internal business practices.
After further analysis and discussions with the industry, the
agencies believe that certain reserves and other internal business
practices could qualify as an EOL offset. Under the proposed rule, a
bank's risk-based capital requirement for operational risk may be based
on UOL alone if the bank can demonstrate it has offset EOL with
eligible operational risk offsets, which are defined as amounts (i)
generated by internal business practices to absorb highly predictable
and reasonably stable operational losses, including reserves calculated
in a manner consistent with GAAP; and (ii) available to cover EOL with
a high degree of certainty over a one-year horizon. Eligible
operational risk offsets may only be used to offset EOL, not UOL.
In determining whether to accept a proposed EOL offset, the
agencies will consider whether the proposed offset would be available
to cover EOL with a high degree of certainty over a one-year horizon.
Supervisory recognition of EOL offsets will be limited to those
business lines and event types with highly predictable, routine losses.
Based on discussions with the industry and empirical data, highly
predictable and routine losses appear to be limited to those relating
to securities processing and to credit card fraud. Question 60: The
agencies are interested in commenters' views on other business lines or
event types in which highly predictable, routine losses have been
observed.
In determining its operational risk exposure, the bank could also
take into account the effects of risk mitigants such as insurance,
subject to approval from its primary Federal supervisor. In order to
recognize the effects of risk mitigants such as insurance for risk-
based capital purposes, the bank must estimate its operational risk
exposure with and without such effects. The reduction in a bank's risk-
based capital requirement for operational risk due to risk mitigants
may not exceed 20 percent of the bank's risk-based capital requirement
for operational risk, after approved adjustments for EOL offsets. A
bank must demonstrate that a risk mitigant is able to absorb losses
with sufficient certainty to warrant inclusion in the adjustment to the
operational risk exposure. For a risk mitigant to meet this standard,
it must be insurance that:
(i) Is provided by an unaffiliated company that has a claims paying
ability that is rated in one of the three highest rating categories by
an NRSRO;
(ii) Has an initial term of at least one year and a residual term
of more than 90 days;
(iii) Has a minimum notice period for cancellation of 90 days;
(iv) Has no exclusions or limitations based upon regulatory action
or for the receiver or liquidator of a failed bank; and
(v) Is explicitly mapped to an actual operational risk exposure of
the bank.
The bank's methodology for recognizing risk mitigants must also
capture, through appropriate discounts in the amount of risk mitigants,
the residual term of the risk mitigant, where less than one year; the
risk mitigant's cancellation terms, where less than one year; the risk
mitigant's timeliness of payment; and the uncertainty of payment as
well as mismatches in coverage between the risk mitigant and the hedged
operational loss event. The bank may not recognize for regulatory
capital purposes risk mitigants with a residual term of 90 days or
less.
Commenters on the ANPR raised concerns that limiting the risk
mitigating benefits of insurance to 20 percent of the bank's regulatory
capital requirement for operational risk represents an overly
prescriptive and arbitrary value. Concerns were raised that such a cap
would inhibit development of this important risk mitigation tool.
Commenters believed that the full contract amount of insurance should
be recognized as the risk mitigating value. The agencies, however,
believe that the 20 percent limit continues to be a prudent limit.
Currently, the primary risk mitigant available for operational risk
is insurance. While certain securities products may be developed over
time that could provide risk mitigation benefits, no specific products
have emerged to-date that have characteristics sufficient to be
considered a capital replacement for operational risk. However, as
innovation in this field continues, a bank may be able to realize the
benefits of risk mitigation through certain capital markets instruments
with the approval of its primary Federal supervisor.
If a bank does not qualify to use or does not have qualifying
operational risk mitigants, the bank's dollar risk-based capital
requirement for operational risk would be its operational
[[Page 55901]]
risk exposure minus eligible operational risk offsets (if any). If a
bank qualifies to use operational risk mitigants and has qualifying
operational risk mitigants, the bank's dollar risk-based capital
requirement for operational risk would be the greater of: (i) The
bank's operational risk exposure adjusted for qualifying operational
risk mitigants minus eligible operational risk offsets (if any); and
(ii) 0.8 multiplied by the difference between the bank's operational
risk exposure and its eligible operational risk offsets (if any). The
dollar risk-based capital requirement for operational risk would be
multiplied by 12.5 to convert it into an equivalent risk-weighted asset
amount. The resulting amount would be added to the comparable amount
for credit risk in calculating the institution's risk-based capital
denominator.
VII. Disclosure
1. Overview
The agencies have long supported meaningful public disclosure by
banks with the objective of improving market discipline. The agencies
recognize the importance of market discipline in encouraging sound risk
management practices and fostering financial stability.
Pillar 3 of the New Accord, market discipline, complements the
minimum capital requirements and the supervisory review process by
encouraging market discipline through enhanced and meaningful public
disclosure. These proposed public disclosure requirements are intended
to allow market participants to assess key information about an
institution's risk profile and its associated level of capital.
The agencies view public disclosure as an important complement to
the advanced approaches to calculating minimum regulatory risk-based
capital requirements, which will be heavily based on internal systems
and methodologies. With enhanced transparency of the advanced
approaches, investors can better evaluate a bank's capital structure,
risk exposures, and capital adequacy. With sufficient and relevant
information, market participants can better evaluate a bank's risk
management performance, earnings potential and financial strength.
Improvements in public disclosures come not only from regulatory
standards, but also through efforts by bank management to improve
communications to public shareholders and other market participants. In
this regard, improvements to risk management processes and internal
reporting systems provide opportunities to significantly improve public
disclosures over time. Accordingly, the agencies strongly encourage the
management of each bank to regularly review its public disclosures and
enhance these disclosures, where appropriate, to clearly identify all
significant risk exposures --whether on-or off-balance sheet--and their
effects on the bank's financial condition and performance, cash flow,
and earnings potential.
Comments on ANPR. Some commenters to the ANPR indicated that the
proposed disclosures were burdensome, excessive, and overly
prescriptive. Other commenters believed that the information provided
in the disclosures would not be comparable across banks because each
bank will use distinct internal methodologies to generate the
disclosures. These commenters also expressed concern that some
disclosures could be misinterpreted or misunderstood by the public.
The agencies believe, however, the required disclosures would
enable market participants to gain key insights regarding a bank's
capital structure, risk exposures, risk assessment processes, and
ultimately, the capital adequacy of the institution. Some of the
proposed disclosure requirements will be new disclosures for banks.
Nonetheless, the agencies believe that a significant amount of the
proposed disclosure requirements are already required by or consistent
with existing GAAP, SEC disclosure requirements, or regulatory
reporting requirements for banks.
2. General Requirements
The public disclosure requirements would apply to the top-tier
legal entity that is a core or opt-in bank within a consolidated
banking group (that is, the top-tier BHC or DI that is a core or opt-in
bank). In general, DIs that are a subsidiary of a BHC or another DI
would not be subject to the disclosure requirements \82\ except that
every DI must disclose total and tier 1 capital ratios and their
components, similar to current requirements. If a DI is not a
subsidiary of a BHC or another DI that must make the full set of
disclosures, the DI must make these disclosures.
---------------------------------------------------------------------------
\82\ The bank regulatory reports and Thrift Financial Reports
will be revised to collect some additional Basel II-related
information, as described below in the regulatory reporting section.
---------------------------------------------------------------------------
The risks to which a bank is exposed and the techniques that it
uses to identify, measure, monitor, and control those risks are
important factors that market participants consider in their assessment
of the institution. Accordingly, each bank that is subject to the
disclosure requirements must have a formal disclosure policy approved
by the board of directors that addresses the institution's approach for
determining the disclosures it should make. The policy should address
the associated internal controls and disclosure controls and
procedures. The board of directors and senior management would be
expected to ensure that appropriate verification of the disclosures
takes place and that effective internal controls and disclosure
controls and procedures are maintained.
A bank should decide which disclosures are relevant for it based on
the materiality concept. Information would be regarded as material if
its omission or misstatement could change or influence the assessment
or decision of a user relying on that information for the purpose of
making investment decisions.
To the extent applicable, a bank would be able to fulfill its
disclosure requirements under this proposed rule by relying on
disclosures made in accordance with accounting standards or SEC
mandates that are very similar to the disclosure requirements in this
proposed rule. In these situations, a bank would explain material
differences between the accounting or other disclosure and the
disclosures required under this proposed rule.
Frequency/timeliness. Consistent with longstanding requirements in
the United States for robust quarterly disclosures in financial and
regulatory reports, and considering the potential for rapid changes in
risk profiles, the agencies would require that quantitative disclosures
be made quarterly. However, qualitative disclosures that provide a
general summary of a bank's risk management objectives and policies,
reporting system, and definitions may be disclosed annually, provided
any significant changes to these are disclosed in the interim. The
disclosures must be timely, that is, must be made no later than the
reporting deadlines for regulatory reports (for example, FR Y-9C) and
financial reports (for example, SEC Forms 10-Q and 10-K). When these
deadlines differ, the later deadline would be used.
In some cases, management may determine that a significant change
has occurred, such that the most recent reported amounts do not reflect
the bank's capital adequacy and risk profile. In those cases, banks
should disclose the general nature of these changes and briefly
describe how they are likely to
[[Page 55902]]
affect public disclosures going forward. These interim disclosures
should be made as soon as practicable after the determination that a
significant change has occurred.
Location of disclosures and audit/certification requirements. The
disclosures would have to be publicly available (for example, included
on a public Web site) for each of the last three years (that is, twelve
quarters) or such shorter time period since the bank entered its first
floor period. Except as discussed below, management would have some
discretion to determine the appropriate medium and location of the
disclosures required by this proposed rule. Furthermore, banks would
have flexibility in formatting their public disclosures, that is, the
agencies are not specifying a fixed format for these disclosures.
Management would be encouraged to provide all of the required
disclosures in one place on the entity's public Web site. The public
Web site address would be reported in a regulatory report (for example,
the FR Y-9C).\83\
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\83\ Alternatively, banks would be permitted to provide the
disclosures in more than one place, as some of them may be included
in public financial reports (for example, in Management's Discussion
and Analysis included in SEC filings) or other regulatory reports
(for example, FR Y-9C Reports). The agencies would require such
banks to provide a summary table on their public Web site that
specifically indicates where all the disclosures may be found (for
example, regulatory report schedules, page numbers in annual
reports).
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Disclosure of tier 1 and total capital ratios must be provided in
the footnotes to the year-end audited financial statements.\84\
Accordingly, these disclosures must be tested by external auditors as
part of the financial statement audit. Disclosures that are not
included in the footnotes to the audited financial statements would not
be required to be subject to external audit reports for financial
statements or internal control reports from management and the external
auditor. However, due to the importance of reliable disclosures, the
agencies would require the chief financial officer to certify that the
disclosures required by the proposed rule are appropriate and that the
board of directors and senior management are responsible for
establishing and maintaining an effective internal control structure
over financial reporting, including the information required by this
proposed rule.
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\84\ These ratios are required to be disclosed in the footnotes
to the audited financial statements pursuant to existing GAAP
requirements in Chapter 17 of the ``AICPA Audit and Accounting Guide
for Depository and Lending Institutions: Banks, Savings
institutions, Credit unions, Finance companies and Mortgage
companies.''
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Proprietary and confidential information. The agencies believe that
the proposed requirements strike an appropriate balance between the
need for meaningful disclosure and the protection of proprietary and
confidential information.\85\ Accordingly, the agencies believe that
banks would be able to provide all of these disclosures without
revealing proprietary and confidential information. However, in rare
cases, disclosure of certain items of information required in the
proposed rule may prejudice seriously the position of a bank by making
public information that is either proprietary or confidential in
nature. In such cases, a reporting bank may request confidential
treatment for the information if the bank believes that disclosure of
specific commercial or financial information in the report would likely
result in substantial harm to its competitive position, or that
disclosure of the submitted information would result in unwarranted
invasion of personal privacy.
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\85\ Proprietary information encompasses information that, if
shared with competitors, would render a bank's investment in these
products/systems less valuable, and, hence, could undermine its
competitive position. Information about customers is often
confidential, in that it is provided under the terms of a legal
agreement or counterparty relationship.
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Question 61: The agencies seek commenters' views on all of the
elements proposed to be captured through the public disclosure
requirements. In particular, the agencies seek comment on the extent to
which the proposed disclosures balance providing market participants
with sufficient information to appropriately assess the capital
strength of individual institutions, fostering comparability from bank
to bank, and reducing burden on the banks that are reporting the
information.
3. Summary of Specific Public Disclosure Requirements
The public disclosure requirements are comprised of 11 tables that
provide important information to market participants on the scope of
application, capital, risk exposures, risk assessment processes, and,
hence, the capital adequacy of the institution. Again, the agencies
note that the substantive content of the tables is the focus of the
disclosure requirements, not the tables themselves. The table numbers
below refer to the table numbers in the proposed rule.
Table 11.1 disclosures, Scope of Application, include a description
of the level in the organization to which the disclosures apply and an
outline of any differences in consolidation for accounting and
regulatory capital purposes, as well as a description of any
restrictions on the transfer of funds and capital within the
organization. These disclosures provide the basic context underlying
regulatory capital calculations.
Table 11.2 disclosures, Capital Structure, provide information on
various components of regulatory capital available to absorb losses and
allow for an evaluation of the quality of the capital available to
absorb losses within the bank.
Table 11.3 disclosures, Capital Adequacy, provide information about
how a bank assesses the adequacy of its capital and require that the
bank disclose its minimum capital requirements for significant risk
areas and portfolios. The table also requires disclosure of the
regulatory capital ratios of the consolidated group and each DI
subsidiary. Such disclosures provide insight into the overall adequacy
of capital based on the risk profile of the organization.
Tables 11.4, 11.5, and 11.7 disclosures, Credit Risk, provide
market participants with insight into different types and
concentrations of credit risk to which the bank is exposed and the
techniques the bank uses to measure, monitor, and mitigate those risks.
These disclosures are intended to enable market participants to assess
the credit risk exposures under the IRB framework, without revealing
proprietary information or duplicating the supervisor's fundamental
review of the bank's IRB framework. Table 11.6 provides the disclosure
requirements related to credit exposures from derivatives. This table
was added as a supplement to the public disclosures initially in the
New Accord as a result of the BCBS's additional efforts to address
certain exposures arising from trading activities. See the July 2005
BCBS publication entitled ``The Application of Basel II to Trading
Activities and the Treatment of Double Default Effects.''
Table 11.8 disclosures, Securitization, provide information to
market participants on the amount of credit risk transferred and
retained by the organization through securitization transactions and
the types of products securitized by the organization. These
disclosures provide users a better understanding of how securitization
transactions impact the credit risk of the bank.
[[Page 55903]]
Table 11.9 disclosures, Operational Risk, provide insight into the
bank's application of the AMA for operational risk and what internal
and external factors are considered in determining the amount of
capital allocated to operational risk.
Table 11.10 disclosures, Equities, provide market participants with
an understanding of the types of equity securities held by the bank and
how they are valued. The table also provides information on the capital
allocated to different equity products and the amount of unrealized
gains and losses.
Table 11.11 disclosures, Interest Rate Risk in Non-Trading
Activities, provide information about the potential risk of loss that
may result from changes in interest rates and how the bank measures
such risk.
4. Regulatory Reporting
In addition to the public disclosures that would be required by the
consolidated banking organization subject to the advanced approaches,
the agencies would require certain additional regulatory reporting from
BHCs, their subsidiary DIs, and DIs applying the advanced approaches
that are not subsidiaries of BHCs. The agencies believe that the
reporting of key risk parameter estimates by each DI applying the
advanced approaches will provide the primary Federal supervisor and
other relevant supervisors with data important for assessing the
reasonableness and accuracy of the institution's calculation of its
minimum capital requirements under this rule and the adequacy of the
institution's capital in relation to its risks. This information would
be collected through regulatory reports. The agencies believe that
requiring certain common reporting across banks will facilitate
comparable application of the proposed rules.
In this regard, the agencies published for comment elsewhere in
today's Federal Register a package of proposed reporting schedules. The
package includes a summary schedule with aggregate data that would be
available to the general public. It also includes supporting schedules
that would be viewed as confidential supervisory information. These
schedules are broken out by exposure category and would collect risk
parameter and other pertinent data in a systematic manner. The agencies
also are exploring ways to obtain information that would improve
supervisors' understanding of the causes behind changes in risk-based
capital requirements. For example, certain data would help explain
whether movements are attributable to changes in key risk parameters or
other factors. Under the proposed rule, banks would begin reporting
this information during their parallel run on a confidential basis. The
agencies will share this information with each other for calibration
and other analytical purposes. Question 62: Comments on regulatory
reporting issues may be submitted in response to this NPR as well as
through the regulatory reporting request for comment noted above.
List of Acronyms
ABCP Asset Backed Commercial Paper
ALLL Allowance for Loan and Lease Losses
AMA Advanced Measurement Approaches
ANPR Advance Notice of Proposed Rulemaking
AVC Asset Value Correlation
BCBS Basel Committee on Banking Supervision
BHC Bank Holding Company
CF Conversion Factor
CEIO Credit-Enhancing Interest-Only Strip
CRM Credit Risk Mitigation
DI Depository Institution
DvP Delivery versus Payment
E Measure of Effectiveness
EAD Exposure at Default
ECL Expected Credit Loss
EL Expected Loss
ELGD Expected Loss Given Default
EOL Expected Operational Loss
FDIC Federal Deposit Insurance Corporation
FFIEC Federal Financial Institutions Examination Council
FMI Future Margin Income
GAAP Generally Accepted Accounting Principles
HELOC Home Equity Line of Credit
HOLA Home Owners' Loan Act
HVCRE High-Volatility Commercial Real Estate
IAA Internal Assessment Approach
IMA Internal Models Approach
IRB Internal Ratings Based
KIRB Capital Requirement for Underlying Pool of Exposures
(securitizations)
LGD Loss Given Default
LTV Loan-to-Value Ratio
M Effective Maturity
MRA Market Risk Amendment
MRC Minimum Risk-Based Capital
OCC Office of the Comptroller of the Currency
OTC Over-the-Counter
OTS Office of Thrift Supervision
PCA Prompt Corrective Action
PD Probability of Default
PFE Potential Future Exposure
PvP Payment versus Payment
QIS-3 Quantitative Impact Study 3
QIS-4 Quantitative Impact Study 4
QIS-5 Quantitative Impact Study 5
QRE Qualifying Revolving Exposure
RBA Ratings-Based Approach
SFA Supervisory Formula Approach
SME Small and Medium-Size Enterprise
SPE Special Purpose Entity
SRWA Simple Risk-Weight Approach
UL Unexpected Loss
UOL Unexpected Operational Loss
VaR Value-at-Risk
Regulatory Flexibility Act Analysis
The Regulatory Flexibility Act (RFA) requires an agency that is
issuing a proposed rule to prepare and make available for public
comment an initial regulatory flexibility analysis that describes the
impact of the proposed rule on small entities. 5 U.S.C. 603(a). The RFA
provides that an agency is not required to prepare and publish an
initial regulatory flexibility analysis if the agency certifies that
the proposed rule will not, if promulgated, have a significant economic
impact on a substantial number of small entities. 5 U.S.C. 605(b).
Pursuant to section 605(b) of the RFA (5 U.S.C. 605(b)), the
agencies certify that this proposed rule will not, if promulgated in
final form, have a significant economic impact on a substantial number
of small entities Pursuant to regulations issued by the Small Business
Administration (13 CFR 121-201), a ``small entity'' includes a bank
holding company, commercial bank, or savings association with assets of
$165 million or less (collectively, small banking organizations). The
proposed rule would require a bank holding company, national bank,
state member bank, state nonmember bank, or savings association to
calculate its risk-based capital requirements according to certain
internal-ratings-based and internal model approaches if the bank
holding company, bank, or savings association (i) has consolidated
total assets (as reported on its most recent year-end regulatory
report) equal to $250 billion or more; (ii) has consolidated total on-
balance sheet foreign exposures at the most recent year-end equal to
$10 billion or more; or (iii) is a subsidiary of a bank holding
company, bank, or savings association that would be required to use the
proposed rule to calculate its risk-based capital requirements.
The agencies estimate that zero small bank holding companies (out
of a total of approximately 2,934 small bank holding companies), five
small national banks (out of a total of approximately 1,090 small
national banks), one small state member bank (out of a total of
approximately 491 small state member banks), one small state nonmember
bank
[[Page 55904]]
(out of a total of approximately 3,249 small state nonmember banks),
and zero small savings associations (out of a total of approximately
446 small savings associations) would be subject to the proposed risk-
based capital requirements on a mandatory basis. In addition, each of
the small banking organizations subject to the proposed rule on a
mandatory basis would be a subsidiary of a bank holding company with
over $250 billion in consolidated total assets or over $10 billion in
consolidated total on-balance sheet foreign exposure. Therefore, the
agencies believe that the proposed rule will not, if promulgated in
final form, result in a significant economic impact on a substantial
number of small entities.
Paperwork Reduction Act
A. Request for Comment on Proposed Information Collection. In
accordance with the requirements of the Paperwork Reduction Act of
1995, the agencies may not conduct or sponsor, and the respondent is
not required to respond to, an information collection unless it
displays a currently valid Office of Management and Budget (OMB)
control number. The agencies are requesting comment on a proposed
information collection. The agencies are also giving notice that the
proposed collection of information has been submitted to OMB for review
and approval.
Comments are invited on:
(a) Whether the collection of information is necessary for the
proper performance of the agencies' functions, including whether the
information has practical utility;
(b) The accuracy of the estimates of the burden of the information
collection, including the validity of the methodology and assumptions
used;
(c) Ways to enhance the quality, utility, and clarity of the
information to be collected;
(d) Ways to minimize the burden of the information collection on
respondents, including through the use of automated collection
techniques or other forms of information technology; and
(e) Estimates of capital or start up costs and costs of operation,
maintenance, and purchase of services to provide information.
Comments should be addressed to:
OCC: Communications Division, Office of the Comptroller of the
Currency, Public Information Room, Mail stop 1-5, Attention: 1557-NEW,
250 E Street, SW., Washington, DC 20219. In addition, comments may be
sent by fax to 202-874-4448, or by electronic mail to
[email protected]. You can inspect and photocopy the comments
at the OCC's Public Information Room, 250 E Street, SW., Washington, DC
20219. You can make an appointment to inspect the comments by calling
202-874-5043.
Board: You may submit comments, identified by Docket No. R-1261, by
any of the following methods:
Agency Web Site: http://www.federalreserve.gov. Follow the
instructions for submitting comments on the http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm.
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
E-mail: [email protected]. Include docket
number in the subject line of the message.
FAX: 202-452-3819 or 202-452-3102.
Mail: Jennifer J. Johnson, Secretary, Board of Governors
of the Federal Reserve System, 20th Street and Constitution Avenue,
NW., Washington, DC 20551.
All public comments are available from the Board's Web site at
http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as
submitted, unless modified for technical reasons. Accordingly, your
comments will not be edited to remove any identifying or contact
information. Public comments may also be viewed electronically or in
paper form in Room MP-500 of the Board's Martin Building (20th and C
Streets, NW.) between 9 a.m. and 5 p.m. on weekdays.
FDIC: You may submit written comments, which should refer to 3064-
AC73, by any of the following methods:
Agency Web Site: http://www.fdic.gov/regulations/laws/federal/propose.html. Follow the instructions for submitting comments
on the FDIC Web site.
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
E-mail: [email protected].
Mail: Robert E. Feldman, Executive Secretary, Attention:
Comments, FDIC, 550 17th Street, NW., Washington, DC 20429.
Hand Delivery/Courier: Guard station at the rear of the
550 17th Street Building (located on F Street) on business days between
7 a.m. and 5 p.m.
Public Inspection: All comments received will be posted without
change to http://www.fdic.gov/regulations/laws/federal/propose/html
including any personal information provided. Comments may be inspected
at the FDIC Public Information Center, Room 100, 801 17th Street, NW.,
Washington, DC, between 9 a.m. and 4:30 p.m. on business days.
A copy of the comments may also be submitted to the OMB desk
officer for the agencies: By mail to U.S. Office of Management and
Budget, 725 17th Street, NW., 10235, Washington, DC 20503 or
by facsimile to 202-395-6974, Attention: Federal Banking Agency Desk
Officer.
OTS: Information Collection Comments, Chief Counsel's Office,
Office of Thrift Supervision, 1700 G Street, NW., Washington, DC 20552;
send a facsimile transmission to (202) 906-6518; or send an e-mail to
[email protected]. OTS will post comments and the
related index on the OTS Internet site at http://www.ots.treas.gov. In
addition, interested persons may inspect the comments at the Public
Reading Room, 1700 G Street, NW., by appointment. To make an
appointment, call (202) 906-5922, send an e-mail to
public.info@ots.treas.gov">public.info@ots.treas.gov, or send a facsimile transmission to (202)
906-7755.
B. Proposed Information Collection. Title of Information
Collection: Risk-Based Capital Standards: Advanced Capital Adequacy
Framework.
Frequency of Response: event-generated.
Affected Public:
OCC: National banks and Federal branches and agencies of foreign
banks.
Board: State member banks, bank holding companies, affiliates and
certain non-bank subsidiaries of bank holding companies, uninsured
state agencies and branches of foreign banks, commercial lending
companies owned or controlled by foreign banks, and Edge and agreement
corporations.
FDIC: Insured nonmember banks, insured state branches of foreign
banks, and certain subsidiaries of these entities.
OTS: Savings associations and certain of their subsidiaries.
Abstract: The proposed rule sets forth a new risk-based capital
adequacy framework that would require some banks and allow other
qualifying banks to use an internal ratings-based approach to calculate
regulatory credit risk capital requirements and advanced measurement
approaches to calculate regulatory operational risk capital
requirements.
The information collection requirements in the proposed rule are
found in sections 21-23, 42, 44, 53, and 71. The collections of
information are necessary in order to implement the proposed advanced
capital adequacy framework.
[[Page 55905]]
Sections 21 and 22 require that a bank adopt a written
implementation plan that addresses how it will comply with the proposed
advanced capital adequacy framework's qualification requirements,
including incorporation of a comprehensive and sound planning and
governance process to oversee the implementation efforts. The bank must
also develop processes for assessing capital adequacy in relation to an
organization's risk profile. It must establish and maintain internal
risk rating and segmentation systems for wholesale and retail risk
exposures, including comprehensive risk parameter quantification
processes and processes for annual reviews and analyses of reference
data to determine their relevance. It must document its process for
identifying, measuring, monitoring, controlling, and internally
reporting operational risk; verify the accurate and timely reporting of
risk-based capital requirements; and monitor, validate, and refine its
advanced systems.
Section 23 requires a bank to notify its primary Federal supervisor
when it makes a material change to its advanced systems and to develop
an implementation plan after any mergers.
Section 42 outlines the capital treatment for securitization
exposures. A bank must disclose publicly that it has provided implicit
support to the securitization and the regulatory capital impact to the
bank of providing such implicit support.
Section 44 describes the IAA. A bank must receive prior written
approval from its primary Federal supervisor before it can use the IAA.
A bank must review and update each internal credit assessment whenever
new material is available, but at least annually. It must validate its
internal credit assessment process on an ongoing basis and at least
annually.
Section 53 outlines the IMA. A bank must receive prior written
approval from its primary Federal supervisor before it can use the IMA.
Section 71 specifies that each consolidated bank must publicly
disclose its total and tier 1 risk-based capital ratios and their
components.
Estimated Burden: The burden estimates below exclude the following:
(1) Any burden associated with changes to the regulatory reports of the
agencies (such as the Consolidated Reports of Income and Condition for
banks (FFIEC 031 and FFIEC 031; OMB Nos. 7100-0036, 3064-0052, 1557-
0081) and the Thrift Financial Report for thrifts (TFR; OMB No. 1550-
0023); (2) any burden associated with capital changes in the Basel II
market risk rule; and (3) any burden associated with the Quantitative
Impact Study (QIS-4 survey, FR 3045; OMB No. 7100-0303). The agencies
are concurrently publishing notices, which will address burden
associated with the first item (published elsewhere in this issue), and
jointly publishing a rulemaking which will address burden associated
with the second item. For the third item, the Federal Reserve
previously took burden for the QIS-4 survey, and some institutions may
leverage the requirements of the QIS-4 survey to fulfill the
requirements of this rule.
The burden associated with this collection of information may be
summarized as follows:
OCC
Number of Respondents: 52.
Estimated Burden Per Respondent: 15,570 hours.
Total Estimated Annual Burden: 809,640 hours.
Board
Number of Respondents: 15.
Estimated Burden Per Respondent: 14,422 hours.
Total Estimated Annual Burden: 216,330 hours.
FDIC
Number of Respondents: 19.
Estimated Burden Per Respondent: 410 hours.
Total Estimated Annual Burden: 7,800 hours.
OTS
Number of Respondents: 4.
Estimated Burden Per Respondent: 15,000 hours.
Total Estimated Annual Burden: 60,000 hours.
Plain Language
Section 722 of the GLB Act requires the agencies to use ``plain
language'' in all proposed and final rules published after January 1,
2000. In light of this requirement, the agencies have sought to present
the proposed rule in a simple and straightforward manner. The agencies
invite comments on whether there are additional steps the agencies
could take to make the proposed rule easier to understand.
OCC Executive Order 12866
Executive Order 12866 requires Federal agencies to prepare a
regulatory impact analysis for agency actions that are found to be
``significant regulatory actions.'' ``Significant regulatory actions''
include, among other things, rulemakings that ``have an annual effect
on the economy of $100 million or more or adversely affect in a
material way the economy, a sector of the economy, productivity,
competition, jobs, the environment, public health or safety, or State,
local, or tribal governments or communities.''\86\ Regulatory actions
that satisfy one or more of these criteria are referred to as
``economically significant regulatory actions.''
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\86\ Executive Order 12866 (September 30, 1993), 58 FR 51735
(October 4, 1993), as amended by Executive Order 13258, 67 FR 9385
(February 28, 2002). For the complete text of the definition of
``significant regulatory action,'' see E.O. 12866 at section 3(f). A
``regulatory action'' is ``any substantive action by an agency
(normally published in the Federal Register) that promulgates or is
expected to lead to the promulgation of a final rule or regulation,
including notices of inquiry, advance notices of proposed
rulemaking, and notices of proposed rulemaking.'' E.O. 12866 at
section 3(e).
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The OCC anticipates that the proposed rule will meet the $100
million criterion and therefore is an economically significant
regulatory action. In conducting the regulatory analysis for an
economically significant regulatory action, Executive Order 12866
requires each Federal agency to provide to the Administrator of the
Office of Management and Budget's (OMB) Office of Information and
Regulatory Affairs (OIRA):
The text of the draft regulatory action, together with a
reasonably detailed description of the need for the regulatory action
and an explanation of how the regulatory action will meet that need;
An assessment of the potential costs and benefits of the
regulatory action, including an explanation of the manner in which the
regulatory action is consistent with a statutory mandate and, to the
extent permitted by law, promotes the President's priorities and avoids
undue interference with State, local, and tribal governments in the
exercise of their governmental functions;
An assessment, including the underlying analysis, of
benefits anticipated from the regulatory action (such as, but not
limited to, the promotion of the efficient functioning of the economy
and private markets, the enhancement of health and safety, the
protection of the natural environment, and the elimination or reduction
of discrimination or bias) together with, to the extent feasible, a
quantification of those benefits;
An assessment, including the underlying analysis, of costs
anticipated from the regulatory action (such as, but not limited to,
the direct cost both to the government in administering the regulation
and to businesses and others in complying with the regulation, and any
adverse effects on the efficient functioning of the economy, private
markets (including productivity, employment, and competitiveness),
health, safety, and the natural environment), together with, to the
[[Page 55906]]
extent feasible, a quantification of those costs; and
An assessment, including the underlying analysis, of costs
and benefits of potentially effective and reasonably feasible
alternatives to the planned regulation, identified by the agencies or
the public (including improving the current regulation and reasonably
viable nonregulatory actions), and an explanation why the planned
regulatory action is preferable to the identified potential
alternatives.
Set forth below is a summary of the OCC's regulatory impact analysis,
which can be found in its entirety at http://www.occ.treas.gov/law/basel.htm under the link of ``Regulatory Impact Analysis for Risk-Based
Capital Standards: Revised Capital Adequacy Guidelines (Basel II),
Office of the Comptroller of the Currency, International and Economic
Affairs (2006)''.
I. The Need for the Regulatory Action.
Federal banking law directs Federal banking agencies, including the
OCC, to require banking organizations to hold adequate capital. The law
authorizes Federal banking agencies to set minimum capital levels to
ensure that banking organizations maintain adequate capital. The law
also gives banking agencies broad discretion with respect to capital
regulation by authorizing them to use any other methods that they deem
appropriate to ensure capital adequacy.
Capital regulation seeks to address market failures that stem from
several sources. Asymmetric information about the risk in a bank's
portfolio creates a market failure by hindering the ability of
creditors and outside monitors to discern a bank's actual risk and
capital adequacy. Moral hazard creates market failure in which the
bank's creditors fail to restrain the bank from taking excessive risks
because deposit insurance either fully or partially protects them from
losses. Public policy addresses these market failures because
individual banks fail to adequately consider the positive externality
or public benefit that adequate capital brings to financial markets and
the economy as a whole.
Capital regulations cannot be static. Innovation in and
transformation of financial markets require periodic reassessments of
what may count as capital and what amount of capital is adequate.
Continuing changes in financial markets create both a need and an
opportunity to refine capital standards in banking. The Basel II
framework, and its proposed implementation in the United States,
reflects an appropriate step forward in addressing these changes.
II. Costs and Benefits of the Proposed Rule.
Under the proposed rule, current capital rules would remain in
effect in 2008 during a parallel run using both current non-Basel II-
based and new Basel II-based capital rules. For the following three
years, the proposed rule would apply limits on the amount by which
minimum required capital may decrease. This analysis, however,
considers the costs and benefits of the proposed rule as fully phased
in.
Cost and benefit analysis of changes in minimum capital
requirements entails considerable measurement problems. On the cost
side, it can be difficult to attribute particular expenditures incurred
by institutions to the costs of implementation because banking
organizations would likely incur some of these costs as part of their
ongoing efforts to improve risk measurement and management systems. On
the benefits side, measurement problems are even greater because the
benefits of the proposal are more qualitative than quantitative.
Measurement problems exist even with an apparently measurable benefit
like lower minimum capital because lower minimum requirements do not
necessarily mean lower capital. Healthy banking organizations generally
hold capital well above regulatory minimums for a variety of reasons,
and the effect of reducing the regulatory minimum is uncertain and may
vary across regulated institutions.
A. Benefits of the Proposed Rule.
1. Better allocation of capital and reduced impact of moral hazard
through reduction in the scope for regulatory arbitrage: By assessing
the amount of capital required for each exposure or pool of exposures,
the advanced approach does away with the simplistic risk buckets of
current capital rules. Eliminating categorical risk weighting and
assigning capital based on measured risk instead greatly curtails or
eliminates the ability of troubled organizations to ``game'' regulatory
capital requirements by finding ways to comply technically with the
requirements while evading their intent and spirit.
2. Improved signal quality of capital as an indicator of solvency:
The advanced approaches of the proposed rule are designed to more
accurately align regulatory capital with risk, which should improve the
quality of capital as an indicator of solvency. The improved signaling
quality of capital will enhance banking supervision and market
discipline.
3. Encourages banking organizations to improve credit risk
management: One of the principal objectives of the proposed rule is to
more closely align capital charges and risk. For any type of credit,
risk increases as either the probability of default or the loss given
default increases. Under the proposed rule, risk weights depend on
these risk measures and consequently capital requirements will more
closely reflect risk. This enhanced link between capital requirements
and risk will encourage banking organizations to improve credit risk
management.
4. More efficient use of required bank capital: Increased risk
sensitivity and improvements in risk measurement will allow prudential
objectives to be achieved more efficiently. If capital rules can better
align capital with risk across the system, a given level of capital
will be able to support a higher level of banking activity while
maintaining the same degree of confidence regarding the safety and
soundness of the banking system. Social welfare is enhanced by either
the stronger condition of the banking system or the increased economic
activity the additional banking services facilitate.
5. Incorporates and encourages advances in risk measurement and
risk management: The proposed rule seeks to improve upon existing
capital regulations by incorporating advances in risk measurement and
risk management made over the past 15 years. An objective of the
proposed rule is to speed adoption of new risk management techniques
and to promote the further development of risk measurement and
management through the regulatory process.
6. Recognizes new developments and accommodates continuing
innovation in financial products by focusing on risk: The proposed rule
also has the benefit of facilitating recognition of new developments in
financial products by focusing on the fundamentals behind risk rather
than on static product categories.
7. Better aligns capital and operational risk and encourages
banking organizations to mitigate operational risk: Introducing an
explicit capital calculation for operational risk eliminates the
implicit and imprecise ``buffer'' that covers operational risk under
current capital rules. Introducing an explicit capital requirement for
operational risk improves assessments of the protection capital
provides, particularly at organizations where operational risk
dominates other risks. The explicit treatment also increases the
transparency of operational risk, which could encourage banking
organizations
[[Page 55907]]
to take further steps to mitigate operational risk.
8. Enhanced supervisory feedback: Although U.S. banking
organizations have long been subject to close supervision, aspects of
all three pillars of the proposed rule aim to enhance supervisory
feedback from Federal banking agencies to managers of banks and
thrifts. Enhanced feedback could further strengthen the safety and
soundness of the banking system.
9. Incorporates market discipline into the regulatory framework:
The proposed rule seeks to introduce market discipline directly into
the regulatory framework by requiring specific disclosures relating to
risk measurement and risk management. Market discipline could
complement regulatory supervision to bolster safety and soundness.
10. Preserves the benefits of international consistency and
coordination achieved with the 1988 Basel Accord: An important
objective of the 1988 Accord was competitive consistency of capital
requirements for banking organizations competing in global markets.
Basel II continues to pursue this objective. Because achieving this
objective depends on the consistency of implementation in the United
States and abroad, the Basel Committee has established an Accord
Implementation Group to promote consistency in the implementation of
Basel II.
11. Ability to opt in offers long-term flexibility to nonmandatory
banking organizations: The proposed U.S. implementation of Basel II
allows banking organizations outside of the mandatory group to
individually judge when the benefits they expect to realize from
adopting the advanced approaches outweigh their costs. Even though the
cost and complexity of adopting the advanced approaches may present
nonmandatory organizations with a substantial hurdle to opting in at
present, the potential long-term benefits of allowing nonmandatory
organizations to partake in the benefits described above may be
similarly substantial.
B. Costs of the Proposed Rule.
Because banking organizations are constantly developing programs
and systems to improve how they measure and manage risk, it is
difficult to distinguish between expenditures explicitly caused by
adoption of the proposed rule and costs that would have occurred
irrespective of any new regulation. In an effort to identify how much
banking organizations expect to spend to comply with the U.S.
implementation of Basel II, the Federal banking agencies included
several questions related to compliance costs in QIS-4.\87\
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\87\ For more information on QIS-4, see Office of the
Comptroller of the Currency, Board of Governors of the Federal
Reserve System, Federal Deposit Insurance Corporation, and Office of
Thrift Supervision, ``Summary Findings of the Fourth Quantitative
Impact Study,'' February 2006, available online at http://www.occ.treas.gov/ftp/release/2006-23a.pdf.
---------------------------------------------------------------------------
1. Overall Costs: According to the 19 out of 26 QIS-4 questionnaire
respondents that provided estimates of their implementation costs,
organizations will spend roughly $42 million on average to adapt to
capital requirements implementing Basel II. Not all of these
respondents are likely mandatory organizations. Counting just the
likely mandatory organizations, the average is approximately $46
million, so there is little difference between organizations that meet
a mandatory threshold and those that do not. Aggregating estimated
expenditures from all 19 respondents indicates that these organizations
will spend a total of $791 million over several years to implement the
proposed rule. Estimated costs for nine respondents meeting one of the
mandatory thresholds come to $412 million.
2. Estimate of costs specific to the proposal: Ten QIS-4
respondents provided estimates of the portion of costs they would have
incurred even if current capital rules remain in effect. Those ten
indicated that they would have spent 45 percent on average, or roughly
half of their Basel II expenditures on improving risk management
anyway. This suggests that of the $42 million organizations expect to
spend on implementation, approximately $21 million may represent
expenditures each institution would have undertaken even without Basel
II. Thus, pure implementation costs may be closer to roughly $395
million for the 19 QIS-4 respondents.
3. Ongoing costs: Seven QIS-4 respondents were able to estimate
what their recurring costs might be under the proposed implementation
of Basel II. On average, the seven organizations estimate that annual
recurring expenses attributable to the proposed capital framework will
be $2.4 million. Organizations indicated that the ongoing costs to
maintain related technology reflect costs for increased personnel and
system maintenance. The larger one-time expenditures primarily involve
money for system development and software purchases.
4. Implicit costs: In addition to explicit setup and recurring
costs, banking organizations may also face implicit costs arising from
the time and inconvenience of having to adapt to new capital
regulations. At a minimum this involves the increased time and
attention required of senior bank and thrift management to introduce
new programs and procedures and the need to closely monitor the new
activities during the inevitable rough patches when the proposed rule
first takes effect.
5. Government administrative costs: OCC expenditures fall into
three broad categories: training, guidance, and supervision. Training
includes expenses for AMA workshops, IRB workshops, and other training
courses and seminars for examiners. Guidance expenses reflect
expenditures on the development of IRB and AMA guidance. Supervision
expenses reflect organization-specific supervisory activities related
to the development and implementation of the Basel II framework. The
largest OCC expenditures have been on the development of IRB and AMA
policy guidance. The $4.6 million spent on guidance represents 65
percent of the estimated total OCC Basel II-related expenditure of $7.1
million through the 2005 fiscal year. In part, this large share
reflects the absence of data for training and supervision costs for
several years, but it also is indicative of the large guidance expenses
in 2002 and 2003 when the Basel II framework was in development. To
date, Basel II expenditures have not been a large part of overall OCC
expenditures. The $3 million spent on Basel II in fiscal year 2005
represents less than one percent of the OCC's $519 million budget for
the year.
6. Total cost: The OCC's estimate of the total cost of the proposed
rule includes expenditures by banking organizations and the OCC from
the present through 2011, the final year of the transition period.
Combining expenditures by mandatory banking organizations and the OCC
provides a present value estimate of $545.9 million for the total cost
of the proposed rule.
7. Procyclicality: Procyclicality refers to the possibility that
banking organizations may reduce lending during economic downturns and
increase lending during economic expansions as a consequence of minimum
capital requirements. There is some concern that the risk-sensitivity
of the IRB approach may cause capital requirements for credit risk to
increase during an economic downturn. Although procyclicality may be
inherent in banking to some extent, elements of the advanced approaches
could reduce inherent procyclicality. Risk management and information
systems may provide bank managers with more
[[Page 55908]]
forward-looking information about risk that would allow them to adjust
portfolios gradually and with more foresight as the economic outlook
changes over the business cycle. Regulatory stress-testing requirements
included in the proposal also will help ensure that institutions
anticipate cyclicality in capital requirements to the greatest extent
possible, reducing the potential economic impact of changes in capital
requirements.
III. Competition Among Providers of Financial Services
One potential concern with any regulatory change is the possibility
that it might create a competitive advantage for some organizations
relative to others, a possibility that certainly applies to a change
with the scope of this proposed rule. However, measurement difficulties
described in the preceding discussion of costs and benefits also extend
to any consideration of the impact on competition. Despite the inherent
difficulty of drawing definitive conclusions, this section considers
various ways in which competitive effects might be manifest, as well as
available evidence related to those potential effects.
1. Explicit Capital for Operational Risk: Some have noted that the
explicit computation of required capital for operational risk could
lead to an increase in total minimum regulatory capital for U.S.
``processing'' banks, generally defined as banking organizations that
tend to engage in a variety of activities related to securities
clearing, asset management, and custodial services. Some have suggested
that the increase in required capital could place such firms at a
competitive disadvantage relative to competitors that do not face a
similar capital requirement. A careful analysis by Fontnouvelle et al
\88\ considers the potential competitive impact of the explicit capital
requirement for operational risk. Overall, the study concludes that
competitive effects from an explicit operational risk capital
requirement should be, at most, extremely modest.
---------------------------------------------------------------------------
\88\ Patrick de Fontnouvelle, Victoria Garrity, Scott Chu, and
Eric Rosengren, ``The Potential Impact of Explicit Operational Risk
Capital Charges on Bank Processing Activities,'' Manuscript, Federal
Reserve Bank of Boston, January 12, 2005. Available at http://www.federalreserve.gov/generalinfo/basel2/whitepapers.htm.
---------------------------------------------------------------------------
2. Residential Mortgage Lending: The issue of competitive effects
has received substantial attention with respect to the residential
mortgage market. The focus on the residential mortgage market stems
from the size and importance of the market in the United States and the
fact that the proposed rule may lead to substantial reductions in
credit-risk capital for residential mortgages. To the extent that
corresponding operational-risk capital requirements do not offset these
credit-risk-related reductions, overall capital requirements for
residential mortgages could decline under the proposed rule. Studies by
Calem and Follain \89\ and Hancock, Lehnert, Passmore, and Sherlund
\90\ suggest that banking organizations operating under capital rules
based on Basel II may increase their holdings of residential mortgages.
Calem and Follain argue that the increase would be significant and come
at the expense of general organizations. Hancock et al. foresee a more
modest increase in residential mortgage holdings at institutions
operating under the new Basel II-based rules, and they see this
increase primarily as a shift away from the large government sponsored
mortgage enterprises.
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\89\ Paul S. Calem and James R. Follain, ``An Examination of How
the Proposed Bifurcated Implementation of Basel II in the U.S. May
Affect Competition Among Banking Organizations for Residential
Mortgages,'' manuscript, January 14, 2005.
\90\ Diana Hancock, Andreas Lehnert, Wayne Passmore, and Shane
M. Sherlund, ``An Analysis of the Potential Competitive Impact of
Basel II Capital Standards on U.S. Mortgage Rates and Mortgage
Securitization'', Federal Reserve Board manuscript, April 2005.
Available at http://www.federalreserve.gov/generalinfo/basel2/whitepapers.htm.
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3. Small Business Lending: One potential avenue for competitive
effects is small-business lending. Smaller banks--those that are less
likely to adopt the advanced approaches to regulatory capital under the
proposed rule--tend to rely more heavily on smaller loans within their
commercial loan portfolios. To the extent that the proposed rule
reduces required capital for such loans, general banking organizations
not operating under the proposed rule might be placed at a competitive
disadvantage. A study by Berger \91\ finds some potential for a
relatively small competitive effect on smaller banks in small business
lending. However, Berger concludes that the small business market for
large banks is very different from the small business market for
smaller banks. For instance, a ``small business'' at a larger banking
organization is usually much larger than small businesses at community
banking organizations.
---------------------------------------------------------------------------
\91\ Allen N. Berger, ``Potential Competitive Effects of Basel
II on Banks in SME Credit Markets in the United States,'' Federal
Reserve Board Finance and Economics Discussion Series, 2004-12.
Available at http://www.federalreserve.gov/generalinfo/basel2/whitepapers.htm.
---------------------------------------------------------------------------
4. Mergers and Acquisitions: Another concern related to potential
changes in competitive conditions under the proposed rule is that
bifurcation of capital standards might change the landscape with regard
to mergers and acquisitions in banking and financial services. For
example, banking organizations operating under the new Basel II-based
capital requirements might be placed in a better position to acquire
other banking organizations operating under the non-Basel II-based
rules, possibly leading to an undesirable consolidation of the banking
sector. Research by Hannan and Pilloff \92\ suggests that the proposed
rule is unlikely to have a significant impact on merger and acquisition
activity in banking.
---------------------------------------------------------------------------
\92\ Timothy H. Hannan and Steven J. Pilloff, ``Will the
Proposed Application of Basel II in the United States Encourage
Increased Bank Merger Activity? Evidence from Past Merger
Activity,'' Federal Reserve Board Finance and Economics Discussion
Series, 2004-13. Available at http://www.federalreserve.gov/generalinfo/basel2/whitepapers.htm.
---------------------------------------------------------------------------
5. Credit Card Competition: The proposed U.S. implementation of
Basel II might also affect competition in the credit card market.
Overall capital requirements for credit card loans could increase under
the proposed rule. This raises the possibility of a change in the
competitive environment among banking organizations subject to the new
Basel II-based capital rules, nonbank credit card issuers, and banking
organizations not subject to the new Basel II-based capital rules. A
study by Lang, Mester, and Vermilyea \93\ finds that implementation of
a rule based on Basel II will not affect credit card competition at
most community and regional banking organizations. The authors also
suggest that higher capital requirements for credit cards may only pose
a modest disadvantage to institutions that are subject to rules based
on Basel II.
---------------------------------------------------------------------------
\93\ William W. Lang, Loretta J. Mester, and Todd A. Vermilyea,
``Potential Competitive Effects on U.S. Bank Credit Card Lending
from the Proposed Bifurcated Application of Basel II,'' manuscript,
December 2005. Available at http://www.federalreserve.gov/generalinfo/basel2/whitepapers.htm.
---------------------------------------------------------------------------
Overall, the evidence regarding the impact of the proposed rule on
competitive equity is mixed. The body of recent economic research
discussed in the body of this report does not reveal persuasive
evidence of any sizeable competitive effects. Nonetheless, the Federal
banking agencies recognize the need to closely monitor the competitive
landscape subsequent to any regulatory change. In particular, the OCC
and other Federal banking agencies will be alert
[[Page 55909]]
for early signs of competitive inequities that might result from this
proposed rule. A multi-year transition period before full
implementation of proposed rules based on Basel II should provide ample
opportunity for the agencies to identify any emerging problems. To the
extent that undesirable competitive inequities emerge, the agencies
have the power to respond to them through many channels, including but
not limited to suitable changes to the capital adequacy regulations.
IV. Analysis of Baseline and Alternatives.
Executive Order 12866 requires a comparison between the proposed
rule, a baseline of what the world would look like without the proposed
rule, and several reasonable alternatives to the proposed rule. In this
regulatory impact analysis, we analyze two baselines and three
alternatives to the proposed rule. We consider two baselines because of
two very different outcomes that depend on the capital rules that other
countries with internationally active banks might adopt absent the
implementation of the Basel II framework in the United States.\94\ The
first baseline considers the possibility that neither the United States
nor these other countries adopt capital rules based on the Basel II
framework. The second baseline analyzes the situation where the United
States does not adopt the proposed rule, but the other countries with
internationally active banking organizations do adopt Basel II.
---------------------------------------------------------------------------
\94\ In addition to the United States, members of the Basel
Committee on Banking Supervision considering Basel II are Belgium,
Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands,
Spain, Sweden, Switzerland, and the United Kingdom.
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A. Presentation of Baselines and Alternatives.
1. Baseline Scenario 1: Current capital standards based on the 1988
Basel Accord continue to apply both here and abroad: Abandoning the
Basel II framework in favor of current capital rules would eliminate
essentially all of the benefits of the proposed rule described earlier.
In place of these lost or diminished benefits, the only advantage of
continuing to apply current capital rules to all banking organizations
is that maintaining the status quo should alleviate concerns regarding
competition among financial service providers. Although the effect of
the proposed rule on competition is uncertain in our estimation,
staying with current capital rules (or universally applying a revised
rule that might emerge from the Basel IA ANPR) eliminates bifurcation
and the explicit assignment of capital for operational risk. Concerns
regarding competition usually center on these two characteristics of
the proposed rule. While continuing to use current capital rules
eliminates most of the benefits of adopting the proposed capital rule,
it does not eliminate many costs associated with Basel II. Because
Basel II costs are difficult to separate from the banking
organization's ordinary development costs and ordinary supervisory
costs at the agencies, dropping the proposal to implement Basel II
would reduce but not eliminate many of these costs associated with the
proposed rule.\95\
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\95\ Cost estimates for adopting a rule that might result from
the Basel IA ANPR are not currently available.
---------------------------------------------------------------------------
2. Baseline Scenario 2: Current capital standards based on the 1988
Basel Accord continue to apply in the United States, but the rest of
the world adopts the Basel II framework: Like the first baseline
scenario, abandoning a framework based on Basel II in favor of current
capital rules would eliminate essentially all of the benefits of the
proposed rule described earlier. Like the first baseline scenario, the
one advantage of this scenario is that there would be no bifurcation of
capital rules within the United States. However, the emergence of
different capital rules across national borders would at least
partially offset this advantage. Thus, while concerns regarding
competition among U.S. financial service providers might diminish in
this scenario, concerns regarding cross-border competition would likely
increase. Just as the first baseline scenario eliminated most of the
benefits of adopting the proposed rule, the same holds true for the
second baseline scenario with one important distinction. Because the
United States would be operating under a set of capital rules different
from the rest of the world, U.S. banking organizations that are
internationally active may face higher costs because they will have to
track and comply with more than one set of capital requirements.
3. Alternative A: Permit U.S. banking organizations to choose among
all three Basel II credit risk approaches: The principal benefit of
Alternative A that the proposed rule does not achieve is the increased
flexibility of the regulation for banking organizations that would be
mandatory banking organizations under the proposed rule. Banking
organizations that are not prepared for the adoption of the advanced
IRB approach to credit risk under the proposed rule could choose to use
the foundation IRB approach or even the standardized approach. How
Alternative A might affect benefits depends entirely on how many
banking organizations select each of the three available options. The
most significant drawback to Alternative A is the increased cost of
applying a new set of capital rules to all U.S. banking organizations.
The vast majority of banking organizations in the United States would
incur no direct costs from new capital rules under the proposed rule.
Under Alternative A, direct costs would increase for every U.S. banking
organization that would have continued with current capital rules under
the proposed rule. Although it is not clear how high these costs might
be, general banking organizations would face higher costs because they
would be changing capital rules regardless of which option they choose
under Alternative A.
4. Alternative B: Permit U.S. banking organizations to choose among
all three Basel II operational risk approaches: The operational risk
approach that banking organizations ultimately selected would determine
how the overall benefits of the new capital regulations would change
under Alternative B. Just as Alternative A increases the flexibility of
credit risk rules for mandatory banking organizations, Alternative B is
more flexible with respect to operational risk. Because the
Standardized Approach tries to be more sensitive to variations in
operational risk than the Basic Indicator Approach and the AMA is more
sensitive than the Standardized Approach, the effect of implementing
Alternative B depends on how many banking organizations select the more
risk sensitive approaches. As was the case with Alternative A, the most
significant drawback to Alternative B is the increased cost of applying
a new set of capital rules to all U.S. banking organizations. Under
Alternative B, direct costs would increase for every U.S. banking
organization that would have continued with current capital rules under
the proposed rule. It is not clear how much it might cost banking
organizations to adopt these capital measures for operational risk, but
general banking organizations would face higher costs because they
would be changing capital rules regardless of which option they choose
under Alternative B.
5. Alternative C: Use a different asset amount to determine a
mandatory organization: The number of mandatory banking organizations
decreases slowly as the size thresholds increase, and the number of
banking organizations grows more quickly as the thresholds decrease.
Under Alternative C, the framework of
[[Page 55910]]
the proposed rule would remain the same and only the number of
mandatory banking organizations would change. Because the structure of
the proposed implementation would remain intact, Alternative C would
capture all of the benefits of the proposed rule. However, because
these benefits derive from applying the proposed rule to individual
banking organizations, changing the number of banking organizations
affected by the rule will change the cumulative level of the benefits
achieved. Generally, the benefits associated with the proposed rule
will rise and fall with the number of mandatory banking organizations.
Because Alternative C would change the number of mandatory banking
organizations subject to the proposed rule, aggregate costs will also
rise or fall with the number of mandatory banking organizations.
B. Overall Comparison of the Proposed Rule with Baselines and
Alternatives.
The Basel II framework and its proposed U.S. implementation seek to
incorporate risk measurement and risk management advances into capital
requirements. On the basis of their analysis, the agencies believe that
the benefits of the proposed rule are significant, durable, and hold
the potential to increase with time. The offsetting costs of
implementing the proposed rule are also significant, but appear to be
largely because of considerable start-up costs. However, much of the
apparent start-up costs reflect activities that the banking
organizations would undertake as part of their ongoing efforts to
improve the quality of their internal risk measurement and management,
even in the absence of Basel II and this proposed rule. The advanced
approaches seem to have fairly modest ongoing expenses. Against these
costs, the significant benefits of Basel II suggest that the proposed
rule offers an improvement over either of the two baseline scenarios.
With regard to the three alternative approaches we consider, the
proposed rule seems to offer an important degree of flexibility while
significantly restricting the cost of the proposed rule by limiting its
application to large, complex, internationally active banking
organizations. Alternatives A and B introduce more flexibility from the
perspective of the large mandatory banking organizations, but each is
less flexible with respect to other banking organizations. Either
Alternative A or B would compel these banking organizations to select a
new set of capital rules and require them to undertake the time and
expense of adjusting to these new rules. Alternative C would change the
number of mandatory banking organizations. If the number of mandatory
banking organizations increases, then the new rule would lose some of
the flexibility the proposed rule achieves with the opt-in option.
Furthermore, costs would increase as the new rule would compel more
banking organizations to incur the expense of adopting the advanced
approaches. Decreasing the number of mandatory banking organizations
would decrease the aggregate social good of each benefit achieved with
the proposed rule. The proposed rule seems to offer a better balance
between costs and benefits than any of the three alternatives.
OTS Executive Order 12866 Determination. OTS commented on the
development of, and concurs with, OCC's RIA. Rather than replicate that
analysis, OTS drafted an RIA incorporating OCC's analysis by reference
and adding appropriate material reflecting the unique aspects of the
thrift industry. The full text of OTS's RIA is available at the
locations for viewing the OTS docket indicated in the ADDRESSES section
above. OTS believes that its analysis meets the requirements of
Executive Order 12866. The following discussion supplements OCC's
summary of its RIA.
The NPR would apply to approximately eight mandatory and potential
opt-in savings associations representing approximately 46 percent of
total thrift industry assets. Approximately 70 percent of the total
assets in these eight institutions are concentrated in residential
mortgage-related assets. By contrast, national banks tend to
concentrate their assets in commercial loans and other kinds of non-
mortgage loans. Only about 35 percent of national bank's total assets
are residential mortgage-related assets. As a result, the costs and
benefits of the NPR for OTS-regulated savings associations will differ
in important ways from OCC-regulated national banks. These differences
are the focus of OTS's analysis.
Benefits. Among the benefits of the NPR, OCC cites: (i) Better
allocation of capital and reduced impact of moral hazard through
reduction in the scope for regulatory arbitrage; (ii) improved signal
quality of capital as an indicator of institution solvency; and (iii)
more efficient use of required bank capital. From OTS's perspective,
however, the NPR may not provide the degree of benefits anticipated by
OCC from these sources.
Because of the low credit risk associated with residential
mortgage-related assets, OTS believes that the risk-insensitive
leverage ratio, rather than the risk-based capital ratio, may be more
binding on its institutions.\96\ As a result, these institutions may be
required to hold more capital than would be required under proposed
credit risk-based standards alone. Therefore, the NPR may cause these
institutions to incur much the same implementation costs as banks with
riskier assets, but with reduced benefits.
---------------------------------------------------------------------------
\96\ The leverage ratio is the ratio of core capital to adjusted
total assets. Under prompt corrective action requirements, savings
associations must maintain a leverage ratio of at least five percent
to be well capitalized and at least four percent to be adequately
capitalized. Basel II will primarily affect the calculation of risk-
weighted assets, rather than the calculation of total assets and
will have only a modest impact on the calculation of core capital.
Thus, the proposed Basel II changes should not significantly affect
the calculated leverage ratio and a savings association that is
currently constrained by the leverage ratio would not significantly
benefit from the Basel II changes.
---------------------------------------------------------------------------
Costs. OTS adopts the OCC cost analysis with the following
supplemental information on OTS's administrative costs. OTS did not
incur a meaningful amount of direct expenditures until 2002 when it
transitioned from a monitoring role to active involvement in Basel II.
Thereafter, expenditures increased rapidly. The OTS expenditures fall
into two broad categories: Policymaking expenses incurred in the
development of the ANPR, this NPR, and related guidance; and
supervision expenses that reflect institution-specific supervisory
activities. OTS estimates that it incurred total expenses of $3,780,000
for fiscal years 2002 through 2005, including $2,640,000 in
policymaking expenses and $1,140,000 in supervision expenses. OTS
anticipates that supervision expenses will continue to grow as a
percentage of the total expense as it moves from policy development to
implementation and training. To date, Basel II expenditures have not
been a large part of overall expenditures.
Competition. OTS agrees with OCC's analysis of competition among
providers of financial services. OTS adds, however, that some
institutions with low credit risk portfolios face an existing
competitive disadvantage because they are bound by a non-risk-based
capital requirement--the leverage ratio. Thus, the agencies regulate a
class of institutions that currently receive fewer capital benefits
from risk-based capital rules because they are bound by the risk-
insensitive leverage ratio. This anomaly will likely continue under the
NPR.
[[Page 55911]]
In addition, the results from QIS-3 and QIS-4 suggest that the
largest reductions in regulatory credit-risk capital requirements from
the application of revised rules would occur in the residential
mortgage loan area. Thus, to the extent regulatory credit-risk capital
requirements affect pricing of such loans, it is possible that core and
opt-in institutions who are not constrained by the leverage ratio may
experience an improvement in their competitive standing vis-[agrave]-
vis non-adopters and vis-[agrave]-vis adopters who are bound by the
leverage ratio. Two research papers--one by Calem and Follain,\97\ and
another by Hancock, Lenhert, Passmore, and Sherlund \98\ addressed this
topic. The Calem and Follain paper argues that Basel II will
significantly affect the competitive environment in mortgage lending;
Hancock, et al. argue that it will not. Both papers are predicated,
however, on the current capital regime for non-adopters. The agencies
recently published an ANPR seeking comment on various modifications to
the existing risk-based capital rules.\99\ These changes may reduce the
competitive disparities between adopters and non-adopters of Basel II
by reducing the competitive advantage of Basel II adopters.
---------------------------------------------------------------------------
\97\ Paul S. Calem and James R. Follain, ``An Examination of How
the Proposed Bifurcated Implementation of Basel II in the U.S. May
Affect Competition Among Banking Organizations for Residential
Mortgages,'' manuscript, January 14, 2005.
\98\ Diana Hancock, Andreas Lenhert, Wayne Passmore, and Shane M
Sherlund, ``An Analysis of the Competitive Impacts of Basel II
Capital Standards on U.S. Mortgage Rates and Mortgage
Securitization, March 7, 2005, Board of Governors of the Federal
Reserve System, working paper.''
\99\ 70 FR 61068 (Oct. 20, 2005).
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Further, residential mortgages are subject to substantial interest
rate risk. The agencies will retain the authority to require additional
capital to cover interest rate risk. If regulatory capital requirements
affect asset pricing, a substantial regulatory capital interest rate
risk component could mitigate any competitive advantages of the
proposed rule. Moreover, the capital requirement for interest rate risk
would be subject to interpretation by each agency. A consistent
evaluation of interest rate risk by the supervisory agencies would
present a level playing field among the adopters--an important
consideration given the potential size of the capital requirement.
OCC Unfunded Mandates Reform Act of 1995 Determination. The
Unfunded Mandates Reform Act of 1995 (Pub. L. 104-4) (UMRA) requires
cost-benefit and other analyses for a rule that would include any
Federal mandate that may result in the expenditure by State, local, and
tribal governments, in the aggregate, or by the private sector of $100
million or more (adjusted annually for inflation) in any one year. The
current inflation-adjusted expenditure threshold is $119.6 million. The
requirements of the UMRA include assessing a rule's effects on future
compliance costs; particular regions or State, local, or tribal
governments; communities; segments of the private sector; productivity;
economic growth; full employment; creation of productive jobs; and the
international competitiveness of U.S. goods and services. The proposed
rule qualifies as a significant regulatory action under the UMRA
because its Federal mandates may result in the expenditure by the
private sector of $119.6 million or more in any one year. As permitted
by section 202(c) of the UMRA, the required analyses have been prepared
in conjunction with the Executive Order 12866 analysis document titled
Regulatory Impact Analysis for Risk-Based Capital Standards: Revised
Capital Adequacy Guidelines. The analysis is available on the Internet
at http://www.occ.treas.gov/law/basel.htm under the link of
``Regulatory Impact Analysis for Risk-Based Capital Standards: Revised
Capital Adequacy Guidelines (Basel II), Office of the Comptroller of
the Currency, International and Economic Affairs (2006)''.
OTS Unfunded Mandates Reform Act of 1995 Determination. The
Unfunded Mandates Reform Act of 1995 (Pub. L. 104-4) (UMRA) requires
cost-benefit and other analyses for a rule that would include any
Federal mandate that may result in the expenditure by State, local, and
tribal governments, in the aggregate, or by the private sector of $100
million or more (adjusted annually for inflation) in any one year. The
current inflation-adjusted expenditure threshold is $119.6 million. The
requirements of the UMRA include assessing a rule's effects on future
compliance costs; particular regions or State, local, or tribal
governments; communities; segments of the private sector; productivity;
economic growth; full employment; creation of productive jobs; and the
international competitiveness of U.S. goods and services. The proposed
rule qualifies as a significant regulatory action under the UMRA
because its Federal mandates may result in the expenditure by the
private sector of $119.6 or more in any one year. As permitted by
section 202(c) of the UMRA, the required analyses have been prepared in
conjunction with the Executive Order 12866 analysis document titled
Regulatory Impact Analysis for Risk-Based Capital Standards: Revised
Capital Adequacy Guidelines. The analysis is available at the locations
for viewing the OTS docket indicated in the ADDRESSES section above.
Text of Common Appendix (All Agencies)
The text of the agencies' common appendix appears below:
[Appendix to Part----]--Capital Adequacy Guidelines for [Bank]s:
\100\ Internal-Ratings-Based and Advanced Measurement Approaches
\1\ For simplicity, and unless otherwise noted, this NPR uses
the term [bank] to include banks, savings associations, and bank
holding companies. [AGENCY] refers to the primary Federal supervisor
of the bank applying the rule.
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Part I General Provisions
Section 1 Purpose, Applicability, and Reservation of Authority
Section 2 Definitions
Section 3 Minimum Risk-Based Capital Requirements
Part II Qualifying Capital
Section 11 Additional Deductions
Section 12 Deductions and Limitations Not Required
Section 13 Eligible Credit Reserves
Part III Qualification
Section 21 Qualification Process
Section 22 Qualification Requirements
Section 23 Ongoing Qualification
Part IV Risk-Weighted Assets for General Credit Risk
Section 31 Mechanics for Calculating Total Wholesale and Retail
Risk-Weighted Assets
Section 32 Counterparty Credit Risk
Section 33 Guarantees and Credit Derivatives: PD Substitution
and LGD Adjustment Treatments
Section 34 Guarantees and Credit Derivatives: Double Default
Treatment
Section 35 Risk-Based Capital Requirement for Unsettled
Transactions
Part V Risk-Weighted Assets for Securitization Exposures
Section 41 Operational Criteria for Recognizing the Transfer of
Risk
Section 42 Risk-Based Capital Requirement for Securitization
Exposures
Section 43 Ratings-Based Approach (RBA)
Section 44 Internal Assessment Approach (IAA)
Section 45 Supervisory Formula Approach (SFA)
Section 46 Recognition of Credit Risk Mitigants for
Securitization Exposures
Section 47 Risk-Based Capital Requirement for Early Amortization
Provisions
Part VI Risk-Weighted Assets for Equity Exposures
Section 51 Introduction and Exposure Measurement
Section 52 Simple Risk Weight Approach (SRWA)
Section 53 Internal Models Approach (IMA)
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Section 54 Equity Exposures to Investment Funds
Section 55 Equity Derivative Contracts
Part VII Risk-Weighted Assets for Operational Risk
Section 61 Qualification Requirements for Incorporation of
Operational Risk Mitigants
Section 62 Mechanics of Risk-Weighted Asset Calculation
Part VIII Disclosure
Section 71 Disclosure Requirements
Part I. General Provisions
Section 1. Purpose, Applicability, and Reservation of Authority
(a) Purpose. This appendix establishes:
(1) Minimum qualifying criteria for [bank]s using [bank]-specific
internal risk measurement and management processes for calculating
risk-based capital requirements;
(2) Methodologies for such [bank]s to calculate their risk-based
capital requirements; and
(3) Public disclosure requirements for such [bank]s.
(b) Applicability. (1) This appendix applies to a [bank] that:
(i) Has consolidated total assets, as reported on the most recent
year-end Consolidated Report of Condition and Income (Call Report) or
Thrift Financial Report (TFR), equal to $250 billion or more;
(ii) Has consolidated total on-balance sheet foreign exposure at
the most recent year-end equal to $10 billion or more (where total on-
balance sheet foreign exposure equals total cross-border claims less
claims with head office or guarantor located in another country plus
redistributed guaranteed amounts to the country of head office or
guarantor plus local country claims on local residents plus revaluation
gains on foreign exchange and derivative products, calculated in
accordance with the Federal Financial Institutions Examination Council
(FFIEC) 009 Country Exposure Report);
(iii) Is a subsidiary of a depository institution that uses 12 CFR
part 3, Appendix C, 12 CFR part 208, Appendix F, 12 CFR part 325,
Appendix D, or 12 CFR part 566, Appendix A, to calculate its risk-based
capital requirements; or
(iv) Is a subsidiary of a bank holding company (as defined in 12
U.S.C. 1841) that uses 12 CFR part 225, Appendix F, to calculate its
risk-based capital requirements.
(2) Any [bank] may elect to use this appendix to calculate its
risk-based capital requirements.
(3) A [bank] that is subject to this appendix must use this
appendix unless the [AGENCY] determines in writing that application of
this appendix is not appropriate in light of the [bank]'s asset size,
level of complexity, risk profile, or scope of operations. In making a
determination under this paragraph, the [AGENCY] will apply notice and
response procedures in the same manner and to the same extent as the
notice and response procedures in 12 CFR 3.12 (for national banks), 12
CFR 263.202 (for bank holding companies and state member banks), 12 CFR
325.6(c) (for state nonmember banks), and 12 CFR 567.3(d) (for savings
associations).
(c) Reservation of authority--(1) Additional capital in the
aggregate. The [AGENCY] may require a [bank] to hold an amount of
capital greater than otherwise required under this appendix if the
[AGENCY] determines that the [bank]'s risk-based capital requirement
under this appendix is not commensurate with the [bank]'s credit,
market, operational, or other risks. In making a determination under
this paragraph, the [AGENCY] will apply notice and response procedures
in the same manner and to the same extent as the notice and response
procedures in 12 CFR 3.12 (for national banks), 12 CFR 263.202 (for
bank holding companies and state member banks), 12 CFR 325.6(c) (for
state nonmember banks), and 12 CFR 567.3(d) (for savings associations).
(2) Specific risk-weighted asset amounts. (i) If the [AGENCY]
determines that the risk-weighted asset amount calculated under this
appendix by the [bank] for one or more exposures is not commensurate
with the risks associated with those exposures, the [AGENCY] may
require the [bank] to assign a different risk-weighted asset amount to
the exposures, to assign different risk parameters to the exposures (if
the exposures are wholesale or retail exposures), or to use different
model assumptions for the exposures (if the exposures are equity
exposures under the Internal Models Approach (IMA) or securitization
exposures under the Internal Assessment Approach (IAA)), all as
specified by the [AGENCY].
(ii) If the [AGENCY] determines that the risk-weighted asset amount
for operational risk produced by the [bank] under this appendix is not
commensurate with the operational risks of the [bank], the [AGENCY] may
require the [bank] to assign a different risk-weighted asset amount for
operational risk, to change elements of its operational risk analytical
framework, including distributional and dependence assumptions, or to
make other changes to the [bank]'s operational risk management
processes, data and assessment systems, or quantification systems, all
as specified by the [AGENCY].
(3) Other supervisory authority. Nothing in this appendix limits
the authority of the [AGENCY] under any other provision of law or
regulation to take supervisory or enforcement action, including action
to address unsafe or unsound practices or conditions, deficient capital
levels, or violations of law.
Section 2. Definitions
Advanced internal ratings-based (IRB) systems means a [bank]'s
internal risk rating and segmentation system; risk parameter
quantification system; data management and maintenance system; and
control, oversight, and validation system for credit risk of wholesale
and retail exposures.
Advanced systems means a [bank]'s advanced IRB systems, operational
risk management processes, operational risk data and assessment
systems, operational risk quantification systems, and, to the extent
the [bank] uses the following systems, the counterparty credit risk
model, double default excessive correlation detection process, IMA for
equity exposures, and IAA for securitization exposures to ABCP
programs.
Affiliate with respect to a company means any company that
controls, is controlled by, or is under common control with, the
company. For purposes of this definition, a person or company controls
a company if it:
(1) Owns, controls, or holds with power to vote 25 percent or more
of a class of voting securities of the company; or
(2) Consolidates the company for financial reporting purposes.
Applicable external rating means, with respect to an exposure, the
lowest external rating assigned to the exposure by any NRSRO.
Asset-backed commercial paper (ABCP) program means a program that
primarily issues commercial paper that:
(1) Has an external rating; and
(2) Is backed by underlying exposures held in a bankruptcy-remote
SPE.
Asset-backed commercial paper (ABCP) program sponsor means a [bank]
that:
(1) Establishes an ABCP program;
(2) Approves the sellers permitted to participate in an ABCP
program;
(3) Approves the exposures to be purchased by an ABCP program; or
(4) Administers the ABCP program by monitoring the underlying
exposures, underwriting or otherwise arranging for the placement of
debt or other obligations issued by the program,
[[Page 55913]]
compiling monthly reports, or ensuring compliance with the program
documents and with the program's credit and investment policy.
Backtesting means the comparison of a [bank]'s internal estimates
with actual outcomes during a sample period not used in model
development. In this context, backtesting is one form of out-of-sample
testing.
Benchmarking means the comparison of a [bank]'s internal estimates
with relevant internal and external data sources or estimation
techniques.
Business environment and internal control factors means the
indicators of a [bank]'s operational risk profile that reflect a
current and forward-looking assessment of the [bank]'s underlying
business risk factors and internal control environment.
Carrying value means, with respect to an asset, the value of the
asset on the balance sheet of the [bank], determined in accordance with
GAAP.
Clean-up call means a contractual provision that permits a servicer
to call securitization exposures before their stated maturity or call
date. See also eligible clean-up call.
Commodity derivative contract means a commodity-linked swap,
purchased commodity-linked option, forward commodity-linked contract,
or any other instrument linked to commodities that gives rise to
similar counterparty credit risks.
Company means a corporation, partnership, limited liability
company, depository institution, business trust, special purpose
entity, association, or similar organization.
Credit derivative means a financial contract executed under
standard industry credit derivative documentation that allows one party
(the protection purchaser) to transfer the credit risk of one or more
exposures (reference exposure) to another party (the protection
provider). See also eligible credit derivative.
Credit-enhancing interest-only strip (CEIO) means an on-balance
sheet asset that, in form or in substance:
(1) Represents a contractual right to receive some or all of the
interest and no more than a minimal amount of principal due on the
underlying exposures of a securitization; and
(2) Exposes the holder to credit risk directly or indirectly
associated with the underlying exposures that exceeds a pro rata share
of the holder's claim on the underlying exposures, whether through
subordination provisions or other credit-enhancement techniques.
Credit-enhancing representations and warranties means
representations and warranties that are made or assumed in connection
with a transfer of underlying exposures (including loan servicing
assets) and that obligate a [bank] to protect another party from losses
arising from the credit risk of the underlying exposures. Credit-
enhancing representations and warranties include provisions to protect
a party from losses resulting from the default or nonperformance of the
obligors of the underlying exposures or from an insufficiency in the
value of the collateral backing the underlying exposures. Credit-
enhancing representations and warranties do not include:
(1) Early default clauses and similar warranties that permit the
return of, or premium refund clauses that cover, first-lien residential
mortgage exposures for a period not to exceed 120 days from the date of
transfer, provided that the date of transfer is within one year of
origination of the residential mortgage exposure;
(2) Premium refund clauses that cover underlying exposures
guaranteed, in whole or in part, by the U.S. government, a U.S.
government agency, or a U.S. government sponsored enterprise, provided
that the clauses are for a period not to exceed 120 days from the date
of transfer; or
(3) Warranties that permit the return of underlying exposures in
instances of misrepresentation, fraud, or incomplete documentation.
Credit risk mitigant means collateral, a credit derivative, or a
guarantee.
Credit-risk-weighted assets means 1.06 multiplied by the sum of:
(1) Total wholesale and retail risk-weighted assets;
(2) Risk-weighted assets for securitization exposures; and
(3) Risk-weighted assets for equity exposures.
Current exposure means, with respect to a netting set, the larger
of zero or the market value of a transaction or portfolio of
transactions within the netting set that would be lost upon default of
the counterparty, assuming no recovery on the value of the
transactions. Current exposure is also called replacement cost.
Default--(1) Retail. (i) A retail exposure of a [bank] is in
default if:
(A) The exposure is 180 days past due, in the case of a residential
mortgage exposure or revolving exposure;
(B) The exposure is 120 days past due, in the case of all other
retail exposures; or
(C) The [bank] has taken a full or partial charge-off or write-down
of principal on the exposure for credit-related reasons.
(ii) A retail exposure in default remains in default until the
[bank] has reasonable assurance of repayment and performance for all
contractual principal and interest payments on the exposure.
(2) Wholesale. (i) A [bank]'s obligor is in default if, for any
wholesale exposure of the [bank] to the obligor, the [bank] has:
(A) Placed the exposure on non-accrual status consistent with the
Call Report Instructions or the TFR and the TFR Instruction Manual;
(B) Taken a full or partial charge-off or write-down on the
exposure due to the distressed financial condition of the obligor; or
(C) Incurred a credit-related loss of 5 percent or more of the
exposure's initial carrying value in connection with the sale of the
exposure or the transfer of the exposure to the held-for-sale,
available-for-sale, trading account, or other reporting category.
(ii) An obligor in default remains in default until the [bank] has
reasonable assurance of repayment and performance for all contractual
principal and interest payments on all exposures of the [bank] to the
obligor (other than exposures that have been fully written-down or
charged-off).
Dependence means a measure of the association among operational
losses across and within business lines and operational loss event
types.
Depository institution is defined in section 3 of the Federal
Deposit Insurance Act (12 U.S.C. 1813).
Derivative contract means a financial contract whose value is
derived from the values of one or more underlying assets, reference
rates, or indices of asset values or reference rates. Derivative
contracts include interest rate derivative contracts, exchange rate
derivative contracts, equity derivative contracts, commodity derivative
contracts, credit derivatives, and any other instrument that poses
similar counterparty credit risks. Derivative contracts also include
unsettled securities, commodities, and foreign exchange transactions
with a contractual settlement or delivery lag that is longer than the
lesser of the market standard for the particular instrument or 5
business days.
Early amortization provision means a provision in the documentation
governing a securitization that, when triggered, causes investors in
the securitization exposures to be repaid before the original stated
maturity of the securitization exposures, unless the provision is
triggered solely by events not directly related to the performance of
the underlying exposures or the originating [bank] (such as material
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changes in tax laws or regulations). An early amortization provision is
a controlled early amortization provision if it meets all the following
conditions:
(1) The originating [bank] has appropriate policies and procedures
to ensure that it has sufficient capital and liquidity available in the
event of an early amortization;
(2) Throughout the duration of the securitization (including the
early amortization period), there is the same pro rata sharing of
interest, principal, expenses, losses, fees, recoveries, and other cash
flows from the underlying exposures based on the originating [bank]'s
and the investors' relative shares of the underlying exposures
outstanding measured on a consistent monthly basis;
(3) The amortization period is sufficient for at least 90 percent
of the total underlying exposures outstanding at the beginning of the
early amortization period to be repaid or recognized as in default; and
(4) The schedule for repayment of investor principal is not more
rapid than would be allowed by straight-line amortization over an 18-
month period.
Economic downturn conditions means, with respect to an exposure,
those conditions in which the aggregate default rates for the
exposure's wholesale or retail exposure subcategory (or subdivision of
such subcategory selected by the [bank]) in the exposure's national
jurisdiction (or subdivision of such jurisdiction selected by the
[bank]) are significantly higher than average.
Effective maturity (M) of a wholesale exposure means:
(1) For wholesale exposures other than repo-style transactions,
eligible margin loans, and OTC derivative contracts subject to a
qualifying master netting agreement:
(i) The weighted-average remaining maturity (measured in years,
whole or fractional) of the expected contractual cash flows from the
exposure, using the undiscounted amounts of the cash flows as weights;
or
(ii) The nominal remaining maturity (measured in years, whole or
fractional) of the exposure.
(2) For repo-style transactions, eligible margin loans, and OTC
derivative contracts subject to a qualifying master netting agreement,
the weighted-average remaining maturity (measured in years, whole or
fractional) of the individual transactions subject to the qualifying
master netting agreement, with the weight of each individual
transaction set equal to the notional amount of the transaction.
Effective notional amount means, for an eligible guarantee or
eligible credit derivative, the lesser of the contractual notional
amount of the credit risk mitigant and the EAD of the hedged exposure,
multiplied by the percentage coverage of the credit risk mitigant. For
example, the effective notional amount of an eligible guarantee that
covers, on a pro rata basis, 40 percent of any losses on a $100 bond
would be $40.
Eligible clean-up call means a clean-up call that:
(1) Is exercisable solely at the discretion of the servicer;
(2) Is not structured to avoid allocating losses to securitization
exposures held by investors or otherwise structured to provide credit
enhancement to the securitization; and
(3) (i) For a traditional securitization, is only exercisable when
10 percent or less of the principal amount of the underlying exposures
or securitization exposures (determined as of the inception of the
securitization) is outstanding; or
(ii) For a synthetic securitization, is only exercisable when 10
percent or less of the principal amount of the reference portfolio of
underlying exposures (determined as of the inception of the
securitization) is outstanding.
Eligible credit derivative means a credit derivative in the form of
a credit default swap, nth-to-default swap, or total return swap
provided that:
(1) The contract meets the requirements of an eligible guarantee
and has been confirmed by the protection purchaser and the protection
provider;
(2) Any assignment of the contract has been confirmed by all
relevant parties;
(3) If the credit derivative is a credit default swap or nth-to-
default swap, the contract includes the following credit events:
(i) Failure to pay any amount due under the terms of the reference
exposure (with a grace period that is closely in line with the grace
period of the reference exposure); and
(ii) Bankruptcy, insolvency, or inability of the obligor on the
reference exposure to pay its debts, or its failure or admission in
writing of its inability generally to pay its debts as they become due,
and similar events;
(4) The terms and conditions dictating the manner in which the
contract is to be settled are incorporated into the contract;
(5) If the contract allows for cash settlement, the contract
incorporates a robust valuation process to estimate loss reliably and
specifies a reasonable period for obtaining post-credit event
valuations of the reference exposure;
(6) If the contract requires the protection purchaser to transfer
an exposure to the protection provider at settlement, the terms of the
exposure provide that any required consent to transfer may not be
unreasonably withheld;
(7) If the credit derivative is a credit default swap or nth-to-
default swap, the contract clearly identifies the parties responsible
for determining whether a credit event has occurred, specifies that
this determination is not the sole responsibility of the protection
provider, and gives the protection purchaser the right to notify the
protection provider of the occurrence of a credit event; and
(8) If the credit derivative is a total return swap and the [bank]
records net payments received on the swap as net income, the [bank]
records offsetting deterioration in the value of the hedged exposure
(either through reductions in fair value or by an addition to
reserves).
Eligible credit reserves means all general allowances that have
been established through a charge against earnings to absorb credit
losses associated with on-or off-balance sheet wholesale and retail
exposures, including the allowance for loan and lease losses (ALLL)
associated with such exposures but excluding allocated transfer risk
reserves established pursuant to 12 U.S.C. 3904 and other specific
reserves created against recognized losses.
Eligible double default guarantor, with respect to a guarantee or
credit derivative obtained by a [bank], means:
(1) U.S.-based entities. A depository institution, a bank holding
company (as defined in section 2 of the Bank Holding Company Act (12
U.S.C. 1841)), a savings and loan holding company (as defined in 12
U.S.C. 1467a) provided all or substantially all of the holding
company's activities are permissible for a financial holding company
under 12 U.S.C. 1843(k), a securities broker or dealer registered
(under the Securities Exchange Act of 1934) with the SEC, an insurance
company in the business of providing credit protection (such as a
monoline bond insurer or re-insurer) that is subject to supervision by
a State insurance regulator, if:
(i) At the time the guarantor issued the guarantee or credit
derivative, the [bank] assigned a PD to the guarantor's rating grade
that was equal to or lower than the PD associated with a long-term
external rating in the third-highest investment grade rating category;
and
(ii) The [bank] currently assigns a PD to the guarantor's rating
grade that is equal to or lower than the PD associated with a long-term
external rating in the lowest investment grade rating category; or
[[Page 55915]]
(2) Non-U.S.-based entities. A foreign bank (as defined in section
211.2 of the Federal Reserve Board's Regulation K (12 CFR 211.2)), a
non-U.S. securities firm, or a non-U.S. based insurance company in the
business of providing credit protection, if:
(i) The [bank] demonstrates that the guarantor is subject to
consolidated supervision and regulation comparable to that imposed on
U.S. depository institutions, securities broker-dealers, or insurance
companies (as the case may be) or has issued and outstanding an
unsecured long-term debt security without credit enhancement that has a
long-term applicable external rating in one of the three highest
investment grade rating categories;
(ii) At the time the guarantor issued the guarantee or credit
derivative, the [bank] assigned a PD to the guarantor's rating grade
that was equal to or lower than the PD associated with a long-term
external rating in the third-highest investment grade rating category;
and
(iii) The [bank] currently assigns a PD to the guarantor's rating
grade that is equal to or lower than the PD associated with a long-term
external rating in the lowest investment grade rating category.
Eligible guarantee means a guarantee that:
(1) Is written and unconditional;
(2) Covers all or a pro rata portion of all contractual payments of
the obligor on the reference exposure;
(3) Gives the beneficiary a direct claim against the protection
provider;
(4) Is non-cancelable by the protection provider for reasons other
than the breach of the contract by the beneficiary;
(5) Is legally enforceable against the protection provider in a
jurisdiction where the protection provider has sufficient assets
against which a judgment may be attached and enforced; and
(6) Requires the protection provider to make payment to the
beneficiary on the occurrence of a default (as defined in the
guarantee) of the obligor on the reference exposure without first
requiring the beneficiary to demand payment from the obligor.
Eligible margin loan means an extension of credit where:
(1) The extension of credit is collateralized exclusively by debt
or equity securities that are liquid and readily marketable;
(2) The collateral is marked to market daily, and the transaction
is subject to daily margin maintenance requirements;
(3) The extension of credit is conducted under an agreement that
provides the [bank] the right to accelerate and terminate the extension
of credit and to liquidate or set off collateral promptly upon an event
of default (including upon an event of bankruptcy, insolvency, or
similar proceeding) of the counterparty, provided that, in any such
case, any exercise of rights under the agreement will not be stayed or
avoided under applicable law in the relevant jurisdictions;\2\ and
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\2\ This requirement is met where all transactions under the
agreement are (i) executed under U.S. law and (ii) constitute
``securities contracts'' or ``repurchase agreements'' under section
555 or 559, respectively, of the Bankruptcy Code (11 U.S.C. 555),
qualified financial contracts under section 11(e)(8) of the Federal
Deposit Insurance Act (12 U.S.C. 1821(e)(8)), or netting contracts
between or among financial institutions under sections 401-407 of
the Federal Deposit Insurance Corporation Improvement Act of 1991
(12 U.S.C. 4401-4407) or the Federal Reserve Board's Regulation EE
(12 CFR part 231).
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(4) The [bank] has conducted and documented sufficient legal review
to conclude with a well-founded basis that the agreement meets the
requirements of paragraph (3) of this definition and is legal, valid,
binding, and enforceable under applicable law in the relevant
jurisdictions.
Eligible operational risk offsets means amounts, not to exceed
expected operational loss, that:
(1) Are generated by internal business practices to absorb highly
predictable and reasonably stable operational losses, including
reserves calculated consistent with GAAP; and
(2) Are available to cover expected operational losses with a high
degree of certainty over a one-year horizon.
Eligible purchased wholesale receivable means a purchased wholesale
receivable that:
(1) The [bank] purchased from an unaffiliated seller and did not
directly or indirectly originate;
(2) Was generated on an arm's-length basis between the seller and
the obligor;\3\
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\3\ Intercompany accounts receivable and receivables subject to
contra-accounts between firms that buy and sell to each other do not
satisfy this criterion.
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(3) Provides the [bank] with a claim on all proceeds from the
receivable or a pro-rata interest in the proceeds from the receivable;
and
(4) Has an M of less than one year.
Eligible securitization guarantor means:
(1) A sovereign entity, the Bank for International Settlements, the
International Monetary Fund, the European Central Bank, the European
Commission, a Federal Home Loan Bank, Federal Agricultural Mortgage
Corporation (Farmer Mac), a multi-lateral development bank, a
depository institution, a bank holding company (as defined in section 2
of the Bank Holding Company Act (12 U.S.C. 1841)), a savings and loan
holding company (as defined in 12 U.S.C. 1467a) provided all or
substantially all of the holding company's activities are permissible
for a financial holding company under 12 U.S.C. 1843(k), a foreign bank
(as defined in section 211.2 of the Federal Reserve Board's Regulation
K (12 CFR 211.2)), or a securities firm;
(2) Any other entity (other than an SPE) that has issued and
outstanding an unsecured long-term debt security without credit
enhancement that has a long-term applicable external rating in one of
the three highest investment grade rating categories; or
(3) Any other entity (other than an SPE) that has a PD assigned by
the [bank] that is lower than or equal to the PD associated with a
long-term external rating in the third highest investment grade rating
category.
Eligible servicer cash advance facility means a servicer cash
advance facility in which:
(1) The servicer is entitled to full reimbursement of advances,
except that a servicer may be obligated to make non-reimbursable
advances for a particular underlying exposure if any such advance is
contractually limited to an insignificant amount of the outstanding
principal balance of that exposure;
(2) The servicer's right to reimbursement is senior in right of
payment to all other claims on the cash flows from the underlying
exposures of the securitization; and
(3) The servicer has no legal obligation to, and does not, make
advances to the securitization if the servicer concludes the advances
are unlikely to be repaid.
Equity derivative contract means an equity-linked swap, purchased
equity-linked option, forward equity-linked contract, or any other
instrument linked to equities that gives rise to similar counterparty
credit risks.
Equity exposure means:
(1) A security or instrument (whether voting or non-voting) that
represents a direct or indirect ownership interest in, and a residual
claim on, the assets and income of a company, unless:
(i) The issuing company is consolidated with the [bank] under GAAP;
(ii) The [bank] is required to deduct the ownership interest from
tier 1 or tier 2 capital under this appendix;
(iii) The ownership interest is redeemable;
(iv) The ownership interest incorporates a payment or other similar
obligation on the part of the issuing
[[Page 55916]]
company (such as an obligation to pay periodic interest); or
(v) The ownership interest is a securitization exposure;
(2) A security or instrument that is mandatorily convertible into a
security or instrument described in paragraph (1) of this definition;
(3) An option or warrant that is exercisable for a security or
instrument described in paragraph (1) of this definition; or
(4) Any other security or instrument (other than a securitization
exposure) to the extent the return on the security or instrument is
based on the performance of a security or instrument described in
paragraph (1) of this definition.
Excess spread for a period means:
(1) Gross finance charge collections and other income received by a
securitization SPE (including market interchange fees) over a period
minus interest paid to the holders of the securitization exposures,
servicing fees, charge-offs, and other senior trust or similar expenses
of the SPE over the period; divided by
(2) The principal balance of the underlying exposures at the end of
the period.
Exchange rate derivative contract means a cross-currency interest
rate swap, forward foreign-exchange contract, currency option
purchased, or any other instrument linked to exchange rates that gives
rise to similar counterparty credit risks.
Excluded mortgage exposure means:
(1) Any one-to-four family residential pre-sold construction loan
or multifamily residential loan that would receive a 50 percent risk
weight under section 618(a)(1) or (b)(1) of the Resolution Trust
Corporation Refinancing, Restructuring, and Improvement Act of 1991
(RTCRRI Act) and under 12 CFR part 3, Appendix A, section 3(a)(3)(iii)
(for national banks), 12 CFR part 208, Appendix A, section III.C.3.
(for state member banks), 12 CFR part 225, Appendix A, section III.C.3.
(for bank holding companies), 12 CFR part 325, Appendix A, section
II.C.a. (for state nonmember banks), or 12 CFR 567.6(a)(1)(iii) and
(iv) (for savings associations); and
(2) Any one-to-four family residential pre-sold construction loan
for a residence for which the purchase contract is cancelled that would
receive a 100 percent risk weight under section 618(a)(2) of the RTCRRI
Act and under 12 CFR part 3, Appendix A, section 3(a)(3)(iii) (for
national banks), 12 CFR part 208, Appendix A, section III.C.3. (for
state member banks), 12 CFR part 225, Appendix A, section III.C.3. (for
bank holding companies), 12 CFR part 325, Appendix A, section II.C.a.
(for state nonmember banks), or 12 CFR 567.6(a)(1)(iii) and (iv) (for
savings associations).
Expected credit loss (ECL) means, for a wholesale exposure to a
non-defaulted obligor or segment of non-defaulted retail exposures, the
product of PD times ELGD times EAD for the exposure or segment. ECL for
a wholesale exposure to a defaulted obligor or segment of defaulted
retail exposures is equal to the [bank]'s impairment estimate for
allowance purposes for the exposure or segment. Total ECL is the sum of
expected credit losses for all wholesale and retail exposures other
than exposures for which the [bank] has applied the double default
treatment in section 34.
Expected exposure (EE) means the expected value of the probability
distribution of credit risk exposures to a counterparty at any
specified future date before the maturity date of the longest term
transaction in the netting set.
Expected loss given default (ELGD) means:
(1) For a wholesale exposure, the [bank]'s empirically based best
estimate of the default-weighted average economic loss, per dollar of
EAD, the [bank] expects to incur in the event that the obligor of the
exposure (or a typical obligor in the loss severity grade assigned by
the [bank] to the exposure) defaults within a one-year horizon over a
mix of economic conditions, including economic downturn conditions.
(2) For a segment of retail exposures, the [bank]'s empirically
based best estimate of the default-weighted average economic loss, per
dollar of EAD, the [bank] expects to incur on exposures in the segment
that default within a one-year horizon over a mix of economic
conditions (including economic downturn conditions).
(3) The economic loss on an exposure in the event of default is all
material credit-related losses on the exposure (including accrued but
unpaid interest or fees, losses on the sale of collateral, direct
workout costs, and an appropriate allocation of indirect workout
costs). Where positive or negative cash flows on a wholesale exposure
to a defaulted obligor or a defaulted retail exposure (including
proceeds from the sale of collateral, workout costs, and draw-downs of
unused credit lines) occur after the date of default, the economic loss
must reflect the net present value of cash flows as of the default date
using a discount rate appropriate to the risk of the defaulted
exposure.
Expected operational loss (EOL) means the expected value of the
distribution of potential aggregate operational losses, as generated by
the [bank]'s operational risk quantification system using a one-year
horizon.
Expected positive exposure (EPE) means the weighted average over
time of expected (non-negative) exposures to a counterparty where the
weights are the proportion of the time interval that an individual
expected exposure represents. When calculating the minimum capital
requirement, the average is taken over a one-year horizon.
Exposure at default (EAD).
(1) For the on-balance sheet component of a wholesale or retail
exposure (other than an OTC derivative contract, repo-style
transaction, or eligible margin loan), EAD means:
(i) If the exposure is held-to-maturity or for trading, the
[bank]'s carrying value (including net accrued but unpaid interest and
fees) for the exposure less any allocated transfer risk reserve for the
exposure; or
(ii) If the exposure is available-for-sale, the [bank]'s carrying
value (including net accrued but unpaid interest and fees) for the
exposure less any allocated transfer risk reserve for the exposure,
less any unrealized gains on the exposure, and plus any unrealized
losses on the exposure.
(2) For the off-balance sheet component of a wholesale or retail
exposure (other than an OTC derivative contract, repo-style
transaction, or eligible margin loan) in the form of a loan commitment
or line of credit, EAD means the [bank]'s best estimate of net
additions to the outstanding amount owed the [bank], including
estimated future additional draws of principal and accrued but unpaid
interest and fees, that are likely to occur over the remaining life of
the exposure assuming the exposure were to go into default. This
estimate of net additions must reflect what would be expected during
economic downturn conditions.
(3) For the off-balance sheet component of a wholesale or retail
exposure (other than an OTC derivative contract, repo-style
transaction, or eligible margin loan) in the form of anything other
than a loan commitment or line of credit, EAD means the notional amount
of the exposure.
(4) EAD for a segment of retail exposures is the sum of the EADs
for each individual exposure in the segment.
(5) EAD for OTC derivative contracts, repo-style transactions, and
eligible margin loans is calculated as described in section 32.
(6) For wholesale or retail exposures in which only the drawn
balance has been securitized, the [bank] must reflect
[[Page 55917]]
its share of the exposures' undrawn balances in EAD. Undrawn balances
of exposures for which the drawn balances have been securitized must be
allocated between the seller's and investors' interests on a pro rata
basis, based on the proportions of the seller's and investors' shares
of the securitized drawn balances.
Exposure category means any of the wholesale, retail,
securitization, or equity exposure categories.
External operational loss event data means, with respect to a
[bank], gross operational loss amounts, dates, recoveries, and relevant
causal information for operational loss events occurring at
organizations other than the [bank].
External rating means a credit rating that is assigned by an NRSRO
to an exposure, provided:
(1) The credit rating fully reflects the entire amount of credit
risk with regard to all payments owed to the holder of the exposure. If
a holder is owed principal and interest on an exposure, the credit
rating must fully reflect the credit risk associated with timely
repayment of principal and interest. If a holder is owed only principal
on an exposure, the credit rating must fully reflect only the credit
risk associated with timely repayment of principal; and
(2) The credit rating is published in an accessible form and is or
will be included in the transition matrices made publicly available by
the NRSRO that summarize the historical performance of positions rated
by the NRSRO.
Financial collateral means collateral:
(1) In the form of:
(i) Cash on deposit with the [bank] (including cash held for the
[bank] by a third-party custodian or trustee);
(ii) Gold bullion;
(iii) Long-term debt securities that have an applicable external
rating of one category below investment grade or higher;
(iv) Short-term debt instruments that have an applicable external
rating of at least investment grade;
(v) Equity securities that are publicly traded;
(vi) Convertible bonds that are publicly traded; or
(vii) Money market mutual fund shares and other mutual fund shares
if a price for the shares is publicly quoted daily; and
(2) In which the [bank] has a perfected, first priority security
interest or the legal equivalent thereof.
GAAP means U.S. generally accepted accounting principles.
Gain-on-sale means an increase in the equity capital (as reported
on Schedule RC of the Call Report, schedule HC of the FR Y-9C Report,
or Schedule SC of the Thrift Financial Report) of a [bank] that results
from a securitization (other than an increase in equity capital that
results from the [bank]'s receipt of cash in connection with the
securitization).
Guarantee means a financial guarantee, letter of credit, insurance,
or other similar financial instrument (other than a credit derivative)
that allows one party (beneficiary) to transfer the credit risk of one
or more specific exposures (reference exposure) to another party
(protection provider). See also eligible guarantee.
High volatility commercial real estate (HVCRE) exposure means a
credit facility that finances or has financed the acquisition,
development, or construction (ADC) of real property, unless the
facility finances:
(1) One-to four-family residential properties; or
(2) Commercial real estate projects in which:
(i) The loan-to-value ratio is less than or equal to the applicable
maximum supervisory loan-to-value ratio in the [AGENCY]'s real estate
lending standards at 12 CFR part 34, Subpart D (OCC); 12 CFR part 208,
Appendix C (Board); 12 CFR part 365, Subpart D (FDIC); and 12 CFR
560.100-560.101 (OTS);
(ii) The borrower has contributed capital to the project in the
form of cash or unencumbered readily marketable assets (or has paid
development expenses out-of-pocket) of at least 15 percent of the real
estate's appraised ``as completed'' value; and
(iii) The borrower contributed the amount of capital required by
paragraph (2)(ii) of this definition before the [bank] advances funds
under the credit facility, and the capital contributed by the borrower,
or internally generated by the project, is contractually required to
remain in the project throughout the life \4\ of the project.
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\4\ The life of a project concludes only when the credit
facility is converted to permanent financing or is sold or paid in
full. Permanent financing may be provided by the [bank] that
provided the ADC facility as long as the permanent financing is
subject to the [bank]'s underwriting criteria for long-term mortgage
loans.
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Inferred rating. A securitization exposure has an inferred rating
equal to the external rating referenced in paragraph (2)(i) of this
definition if:
(1) The securitization exposure does not have an external rating;
and
(2) Another securitization exposure issued by the same issuer and
secured by the same underlying exposures:
(i) Has an external rating;
(ii) Is subordinated in all respects to the unrated securitization
exposure;
(iii) Does not benefit from any credit enhancement that is not
available to the unrated securitization exposure; and
(iv) Has an effective remaining maturity that is equal to or longer
than that of the unrated securitization exposure.
Interest rate derivative contract means a single-currency interest
rate swap, basis swap, forward rate agreement, purchased interest rate
option, when-issued securities, or any other instrument linked to
interest rates that gives rise to similar counterparty credit risks.
Internal operational loss event data means, with respect to a
[bank], gross operational loss amounts, dates, recoveries, and relevant
causal information for operational loss events occurring at the [bank].
Investing [bank] means, with respect to a securitization, a [bank]
that assumes the credit risk of a securitization exposure (other than
an originating [bank] of the securitization). In the typical synthetic
securitization, the investing [bank] sells credit protection on a pool
of underlying exposures to the originating [bank].
Investment fund means a company:
(1) All or substantially all of the assets of which are financial
assets; and
(2) That has no material liabilities.
Investors' interest EAD means, with respect to a securitization,
the EAD of the underlying exposures multiplied by the ratio of:
(1) The total amount of securitization exposures issued by the SPE
to investors; divided by
(2) The outstanding principal amount of underlying exposures.
Loss given default (LGD) means:
(1) For a wholesale exposure:
(i) If the [bank] has received prior written approval from [AGENCY]
to use internal estimates of LGD for the exposure's wholesale exposure
subcategory, the greater of:
(A) The [bank]'s ELGD for the exposure (or for the typical exposure
in the loss severity grade assigned by the [bank] to the exposure); or
(B) The [bank]'s empirically based best estimate of the economic
loss, per dollar of EAD, the [bank] would expect to incur if the
obligor (or a typical obligor in the loss severity grade assigned by
the [bank] to the exposure) were to default within a one-year horizon
during economic downturn conditions.
(ii) If the [bank] has not received such prior approval,
(A) For an exposure that is not a repo-style transaction, eligible
margin loan, or OTC derivative contract, the sum of:
(1) 0.08; and
[[Page 55918]]
(2) 0.92 multiplied by the [bank]'s ELGD for the exposure (or for
the typical exposure in the loss severity grade assigned by the [bank]
to the exposure); or
(B) For an exposure that is a repo-style transaction, eligible
margin loan, or OTC derivative contract, the [bank]'s ELGD for the
exposure (or for the typical exposure in the loss severity grade
assigned by the [bank] to the exposure).
(2) For a segment of retail exposures:
(i) If the [bank] has received prior written approval from [AGENCY]
to use internal estimates of LGD for the segment's retail exposure
subcategory, the greater of:
(A) The [bank]'s ELGD for the segment of exposures; or
(B) The [bank]'s empirically based best estimate of the economic
loss, per dollar of EAD, the [bank] would expect to incur on exposures
in the segment that default within a one-year horizon during economic
downturn conditions.
(ii) If the [bank] has not received such prior approval,
(A) For a segment of exposures that are not eligible margin loans,
the sum of:
(1) 0.08; and
(2) 0.92 multiplied by the [bank]'s ELGD for the segment of
exposures; or
(B) For a segment of exposures that are eligible margin loans, the
[bank]'s ELGD for the segment of exposures.
(3) In approving a [bank]'s use of internal estimates of LGD for a
wholesale or retail exposure subcategory, [AGENCY] will consider
whether:
(A) The [bank]'s internal estimates of LGD are reliable and
sufficiently reflective of economic downturn conditions; and
(B) The [bank] has rigorous and well-documented policies and
procedures for identifying economic downturn conditions for the
exposure subcategory, identifying material adverse correlations between
the relevant drivers of default rates and loss rates given default, and
incorporating identified correlations into internal LGD estimates.
(4) The economic loss on an exposure in the event of default is all
material credit-related losses on the exposure (including accrued but
unpaid interest or fees, losses on the sale of collateral, direct
workout costs, and an appropriate allocation of indirect workout
costs). Where positive or negative cash flows on a wholesale exposure
to a defaulted obligor or a defaulted retail exposure (including
proceeds from the sale of collateral, workout costs, and draw-downs of
unused credit lines) occur after the date of default, the economic loss
must reflect the net present value of cash flows as of the default date
using a discount rate appropriate to the risk of the defaulted
exposure.
Main index means the Standard & Poor's 500 Index, the FTSE All-
World Index, and any other index for which the [bank] can demonstrate
to the satisfaction of [AGENCY] that the equities represented in the
index have comparable liquidity, depth of market, and size of bid-ask
spreads as equities in the Standard & Poor's 500 Index and FTSE All-
World Index.
Multi-lateral development bank means any multi-lateral lending
institution or regional development bank in which the U.S. government
is a shareholder or contributing member.
Nationally recognized statistical rating organization (NRSRO) means
an entity recognized by the Division of Market Regulation (or any
successor division) of the SEC as a nationally recognized statistical
rating organization for various purposes, including the SEC's net
capital requirements for securities broker-dealers.
Netting set means a group of transactions with a single
counterparty that are subject to a qualifying master netting agreement
or qualifying cross-product master netting agreement. Each transaction
that is not subject to such a master netting agreement is its own
netting set.
Nth-to-default credit derivative means a credit derivative that
provides credit protection only for the nth-defaulting reference
exposure in a group of reference exposures.
Operational loss means a loss (excluding insurance or tax effects)
resulting from an operational loss event. Operational loss includes all
expenses associated with an operational loss event except for
opportunity costs, forgone revenue, and costs related to risk
management and control enhancements implemented to prevent future
operational losses.
Operational loss event means an event that results in loss and is
associated with internal fraud; external fraud; \5\ employment
practices and workplace safety; clients, products, and business
practices; damage to physical assets; business disruption and system
failures; or execution, delivery, and process management.
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\5\ Retail credit card losses arising from non-contractual,
third-party initiated fraud (for example, identity theft) are
external fraud operational losses. All other third-party initiated
credit losses are to be treated as credit risk losses.
---------------------------------------------------------------------------
Operational risk means the risk of loss resulting from inadequate
or failed internal processes, people, and systems or from external
events (including legal risk but excluding strategic and reputational
risk).
Operational risk exposure means the 99.9th percentile of the
distribution of potential aggregate operational losses, as generated by
the [bank]'s operational risk quantification system over a one-year
horizon (and not incorporating eligible operational risk offsets or
qualifying operational risk mitigants).
Originating [bank], with respect to a securitization, means a
[bank] that:
(1) Directly or indirectly originated or securitized the underlying
exposures included in the securitization; or
(2) Serves as an ABCP program sponsor to the securitization.
Other retail exposure means an exposure (other than a
securitization exposure, an equity exposure, a residential mortgage
exposure, an excluded mortgage exposure, a qualifying revolving
exposure, or the residual value portion of a lease exposure) that is
managed as part of a segment of exposures with homogeneous risk
characteristics, not on an individual-exposure basis, and is either:
(1) An exposure to an individual for non-business purposes; or
(2) An exposure to an individual or company for business purposes
if the [bank]'s consolidated business credit exposure to the individual
or company is $1 million or less.
Over-the-counter (OTC) derivative contract means a derivative
contract that is not traded on an exchange that requires the daily
receipt and payment of cash-variation margin.
Parallel run period means a period of at least four consecutive
quarters after adoption of the [bank]'s implementation plan and before
the [bank]'s first floor period during which the [bank] complies with
all the qualification requirements in section 22 to the satisfaction of
the [AGENCY].
Probability of default (PD) means:
(1) For a wholesale exposure to a non-defaulted obligor, the
[bank]'s empirically based best estimate of the long-run average of
one-year default rates for the rating grade assigned by the [bank] to
the obligor, capturing the average default experience for obligors in a
rating grade over a mix of economic conditions (including economic
downturn conditions) sufficient to provide a reasonable estimate of the
average one-year default rate over the economic cycle for the rating
grade.
(2) For a segment of non-defaulted retail exposures for which
seasoning effects are not material, or for a segment of non-defaulted
retail exposures in a retail exposure subcategory for which seasoning
effects are not material, the
[[Page 55919]]
[bank]'s empirically based best estimate of the long-run average of
one-year default rates for the exposures in the segment, capturing the
average default experience for exposures in the segment over a mix of
economic conditions (including economic downturn conditions) sufficient
to provide a reasonable estimate of the average one-year default rate
over the economic cycle for the segment.
(3) For any other segment of non-defaulted retail exposures, the
[bank]'s empirically based best estimate of the annualized cumulative
default rate over the expected remaining life of exposures in the
segment, capturing the average default experience for exposures in the
segment over a mix of economic conditions (including economic downturn
conditions) sufficient to provide a reasonable estimate of the average
performance over the economic cycle for the segment.
(4) For a wholesale exposure to a defaulted obligor or segment of
defaulted retail exposures, 100 percent.
Protection amount (P) means, with respect to an exposure hedged by
an eligible guarantee or eligible credit derivative, the effective
notional amount of the guarantee or credit derivative as reduced to
reflect any currency mismatch, maturity mismatch, or lack of
restructuring coverage (as provided in section 33).
Publicly traded means traded on:
(1) Any exchange registered with the SEC as a national securities
exchange under section 6 of the Securities Exchange Act of 1934 (15
U.S.C. 78f); or
(2) Any non-U.S.-based securities exchange that:
(i) Is registered with, or approved by, a national securities
regulatory authority; and
(ii) Provides a liquid, two-way market for the instrument in
question, meaning that there are enough independent bona fide offers to
buy and sell so that a sales price reasonably related to the last sales
price or current bona fide competitive bid and offer quotations can be
determined promptly and a trade can be settled at such a price within
five business days.
Qualifying central counterparty means a counterparty (for example,
a clearing house) that:
(1) Facilitates trades between counterparties in one or more
financial markets by either guaranteeing trades or novating contracts;
(2) Requires all participants in its arrangements to be fully
collateralized on a daily basis; and
(3) The [bank] demonstrates to the satisfaction of [AGENCY] is in
sound financial condition and is subject to effective oversight by a
national supervisory authority.
Qualifying cross-product master netting agreement means a
qualifying master netting agreement that provides for termination and
close-out netting across multiple types of financial transactions or
qualifying master netting agreements in the event of a counterparty's
default, provided that:
(1) The underlying financial transactions are OTC derivative
contracts, eligible margin loans, or repo-style transactions; and
(2) The [bank] obtains a written legal opinion verifying the
validity and enforceability of the agreement under applicable law of
the relevant jurisdictions if the counterparty fails to perform upon an
event of default, including upon an event of bankruptcy, insolvency, or
similar proceeding.
Qualifying master netting agreement means any written, legally
enforceable bilateral agreement, provided that:
(1) The agreement creates a single legal obligation for all
individual transactions covered by the agreement upon an event of
default, including bankruptcy, insolvency, or similar proceeding, of
the counterparty;
(2) The agreement provides the [bank] the right to accelerate,
terminate, and close-out on a net basis all transactions under the
agreement and to liquidate or set off collateral promptly upon an event
of default, including upon an event of bankruptcy, insolvency, or
similar proceeding, of the counterparty, provided that, in any such
case, any exercise of rights under the agreement will not be stayed or
avoided under applicable law in the relevant jurisdictions;
(3) The [bank] has conducted and documented sufficient legal review
to conclude with a well-founded basis that:
(i) The agreement meets the requirements of paragraph (2) of this
definition; and
(ii) In the event of a legal challenge (including one resulting
from default or from bankruptcy, insolvency, or similar proceeding) the
relevant court and administrative authorities would find the agreement
to be legal, valid, binding, and enforceable under the law of the
relevant jurisdictions;
(4) The [bank] establishes and maintains procedures to monitor
possible changes in relevant law and to ensure that the agreement
continues to satisfy the requirements of this definition; and
(5) The agreement does not contain a walkaway clause (that is, a
provision that permits a non-defaulting counterparty to make a lower
payment than it would make otherwise under the agreement, or no payment
at all, to a defaulter or the estate of a defaulter, even if the
defaulter or the estate of the defaulter is a net creditor under the
agreement).
Qualifying revolving exposure (QRE) means an exposure (other than a
securitization exposure or equity exposure) to an individual that is
managed as part of a segment of exposures with homogeneous risk
characteristics, not on an individual-exposure basis, and:
(1) Is revolving (that is, the amount outstanding fluctuates,
determined largely by the borrower's decision to borrow and repay, up
to a pre-established maximum amount);
(2) Is unsecured and unconditionally cancelable by the [bank] to
the fullest extent permitted by Federal law; and
(3) Has a maximum exposure amount (drawn plus undrawn) of up to
$100,000.
Repo-style transaction means a repurchase or reverse repurchase
transaction, or a securities borrowing or securities lending
transaction, including a transaction in which the [bank] acts as agent
for a customer and indemnifies the customer against loss, provided
that:
(1) The transaction is based solely on liquid and readily
marketable securities or cash;
(2) The transaction is marked-to-market daily and subject to daily
margin maintenance requirements;
(3) The transaction is executed under an agreement that provides
the [bank] the right to accelerate, terminate, and close-out the
transaction on a net basis and to liquidate or set off collateral
promptly upon an event of default (including upon an event of
bankruptcy, insolvency, or similar proceeding) of the counterparty,
provided that, in any such case, any exercise of rights under the
agreement will not be stayed or avoided under applicable law in the
relevant jurisdictions; \6\ and
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\6\ This requirement is met where all transactions under the
agreement are (i) executed under U.S. law and (ii) constitute
``securities contracts'' or ``repurchase agreements'' under section
555 or 559, respectively, of the Bankruptcy Code (11 U.S.C. 555 or
559), qualified financial contracts under section 11(e)(8) of the
Federal Deposit Insurance Act (12 U.S.C. 1821(e)(8)), or netting
contracts between or among financial institutions under sections
401-407 of the Federal Deposit Insurance Corporation Improvement Act
of 1991 (12 U.S.C. 4401-4407) or the Federal Reserve Board's
Regulation EE (12 CFR part 231).
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(4) The [bank] has conducted and documented sufficient legal review
to conclude with a well-founded basis that the agreement meets the
requirements of paragraph (3) of this definition and is legal, valid,
binding, and enforceable
[[Page 55920]]
under applicable law in the relevant jurisdictions.
Residential mortgage exposure means an exposure (other than a
securitization exposure, equity exposure, or excluded mortgage
exposure) that is managed as part of a segment of exposures with
homogeneous risk characteristics, not on an individual-exposure basis,
and is:
(1) An exposure that is primarily secured by a first or subsequent
lien on one-to four-family residential property; or
(2) An exposure with an original and outstanding amount of $1
million or less that is primarily secured by a first or subsequent lien
on residential property that is not one-to four-family.
Retail exposure means a residential mortgage exposure, a qualifying
revolving exposure, or an other retail exposure.
Retail exposure subcategory means the residential mortgage
exposure, qualifying revolving exposure, or other retail exposure
subcategory.
Risk parameter means a variable used in determining risk-based
capital requirements for wholesale and retail exposures, specifically
probability of default (PD), expected loss given default (ELGD), loss
given default (LGD), exposure at default (EAD), or effective maturity
(M).
Scenario analysis means a systematic process of obtaining expert
opinions from business managers and risk management experts to derive
reasoned assessments of the likelihood and loss impact of plausible
high-severity operational losses.
SEC means the U.S. Securities and Exchange Commission.
Securitization means a traditional securitization or a synthetic
securitization.
Securitization exposure means:
(1) An on-balance sheet or off-balance sheet credit exposure that
arises from a traditional or synthetic securitization (including
credit-enhancing representations and warranties); and
(2) Mortgage-backed pass-through securities guaranteed by Fannie
Mae or Freddie Mac.
Senior securitization exposure means a securitization exposure that
has a first priority claim on the cash flows from the underlying
exposures, disregarding the claims of a service provider (such as a
swap counterparty or trustee, custodian, or paying agent for the
securitization) to fees from the securitization. A liquidity facility
that supports an ABCP program is a senior securitization exposure if
the liquidity facility provider's right to reimbursement of the drawn
amounts is senior to all claims on the cash flows from the underlying
exposures except claims of a service provider to fees.
Servicer cash advance facility means a facility under which the
servicer of the underlying exposures of a securitization may advance
cash to ensure an uninterrupted flow of payments to investors in the
securitization, including advances made to cover foreclosure costs or
other expenses to facilitate the timely collection of the underlying
exposures. See also eligible servicer cash advance facility.
Sovereign entity means a central government (including the U.S.
government) or an agency, department, ministry, or central bank of a
central government.
Sovereign exposure means:
(1) A direct exposure to a sovereign entity; or
(2) An exposure directly and unconditionally backed by the full
faith and credit of a sovereign entity.
Special purpose entity (SPE) means a corporation, trust, or other
entity organized for the specific purpose of holding underlying
exposures of a securitization, the activities of which are limited to
those appropriate to accomplish this purpose, and the structure of
which is intended to isolate the underlying exposures held by the
entity from the credit risk of the seller of the underlying exposures
to the entity.
Synthetic securitization means a transaction in which:
(1) All or a portion of the credit risk of one or more underlying
exposures is transferred to one or more third parties through the use
of one or more credit derivatives or guarantees (other than a guarantee
that transfers only the credit risk of an individual retail exposure);
(2) The credit risk associated with the underlying exposures has
been separated into at least two tranches reflecting different levels
of seniority;
(3) Performance of the securitization exposures depends upon the
performance of the underlying exposures; and
(4) All or substantially all of the underlying exposures are
financial exposures (such as loans, commitments, credit derivatives,
guarantees, receivables, asset-backed securities, mortgage-backed
securities, other debt securities, or equity securities).
Tier 1 capital is defined in [the general risk-based capital
rules], as modified in part II of this appendix.
Tier 2 capital is defined in [the general risk-based capital
rules], as modified in part II of this appendix.
Total qualifying capital means the sum of tier 1 capital and tier 2
capital, after all deductions required in this appendix.
Total risk-weighted assets means:
(1) The sum of:
(i) Credit risk-weighted assets; and
(ii) Risk-weighted assets for operational risk; minus
(2) The sum of:
(i) Excess eligible credit reserves not included in tier 2 capital;
and
(ii) Allocated transfer risk reserves.
Total wholesale and retail risk-weighted assets means the sum of
risk-weighted assets for wholesale exposures to non-defaulted obligors
and segments of non-defaulted retail exposures; risk-weighted assets
for wholesale exposures to defaulted obligors and segments of defaulted
retail exposures; risk-weighted assets for assets not defined by an
exposure category; and risk-weighted assets for non-material portfolios
of exposures (all as determined in section 31) and risk-weighted assets
for unsettled transactions (as determined in section 35) minus the
amounts deducted from capital pursuant to [the general risk-based
capital rules] (excluding those deductions reversed in section 12).
Traditional securitization means a transaction in which:
(1) All or a portion of the credit risk of one or more underlying
exposures is transferred to one or more third parties other than
through the use of credit derivatives or guarantees;
(2) The credit risk associated with the underlying exposures has
been separated into at least two tranches reflecting different levels
of seniority;
(3) Performance of the securitization exposures depends upon the
performance of the underlying exposures; and
(4) All or substantially all of the underlying exposures are
financial exposures (such as loans, commitments, credit derivatives,
guarantees, receivables, asset-backed securities, mortgage-backed
securities, other debt securities, or equity securities).
Tranche means all securitization exposures associated with a
securitization that have the same seniority level.
Underlying exposures means one or more exposures that have been
securitized in a securitization transaction.
Unexpected operational loss (UOL) means the difference between the
[bank]'s operational risk exposure and the [bank]'s expected
operational loss.
Unit of measure means the level (for example, organizational unit
or operational loss event type) at which the [bank]'s operational risk
quantification system generates a separate distribution of potential
operational losses.
[[Page 55921]]
Value-at-Risk (VaR) means the estimate of the maximum amount that
the value of one or more exposures could decline due to market price or
rate movements during a fixed holding period within a stated confidence
interval.
Wholesale exposure means a credit exposure to a company,
individual, sovereign, or governmental entity (other than a
securitization exposure, retail exposure, excluded mortgage exposure,
or equity exposure). Examples of a wholesale exposure include:
(1) A non-tranched guarantee issued by a [bank] on behalf of a
company;
(2) A repo-style transaction entered into by a [bank] with a
company and any other transaction in which a [bank] posts collateral to
a company and faces counterparty credit risk;
(3) An exposure that the [bank] treats as a covered position under
[the market risk rule] for which there is a counterparty credit risk
charge in section 32;
(4) A sale of corporate loans by a [bank] to a third party in which
the [bank] retains full recourse;
(5) An OTC derivative contract entered into by a [bank] with a
company;
(6) An exposure to an individual that is not managed by the [bank]
as part of a segment of exposures with homogeneous risk
characteristics; and
(7) A commercial lease.
Wholesale exposure subcategory means the HVCRE or non-HVCRE
wholesale exposure subcategory.
Section 3. Minimum Risk-Based Capital Requirements
(a) Except as modified by paragraph (c) of this section or by
section 23, each [bank] must meet a minimum ratio of:
(1) Total qualifying capital to total risk-weighted assets of 8.0
percent; and
(2) Tier 1 capital to total risk-weighted assets of 4.0 percent.
(b) Each [bank] must hold capital commensurate with the level and
nature of all risks to which the [bank] is exposed.
(c) When a [bank] subject to [the market risk rule] calculates its
risk-based capital requirements under this appendix, the [bank] must
also refer to [the market risk rule] for supplemental rules to
calculate risk-based capital requirements adjusted for market risk.
Part II. Qualifying Capital
Section 11. Additional Deductions
(a) General. A [bank] that uses this appendix must make the same
deductions from its tier 1 capital and tier 2 capital required in [the
general risk-based capital rules], except that:
(1) A [bank] is not required to deduct certain equity investments
and CEIOs (as explained in more detail in section 12); and
(2) A [bank] also must make the deductions from capital required by
paragraphs (b) and (c) of this section.
(b) Deductions from tier 1 capital. A [bank] must deduct from tier
1 capital any gain-on-sale associated with a securitization exposure as
provided in paragraph (a) of section 41 and paragraphs (a)(1), (c),
(g)(1), and (h)(1) of section 42.
(c) Deductions from tier 1 and tier 2 capital. A [bank] must deduct
the following exposures 50 percent from tier 1 capital and 50 percent
from tier 2 capital. If the amount deductible from tier 2 capital
exceeds the [bank]'s actual tier 2 capital, however, the [bank] must
deduct the shortfall amount from tier 1 capital.
(1) Credit-enhancing interest-only strips (CEIOs). In accordance
with paragraphs (a)(1) and (c) of section 42, any CEIO that does not
constitute gain-on-sale.
(2) Non-qualifying securitization exposures. In accordance with
paragraphs (a)(4) and (c) of section 42, any securitization exposure
that does not qualify for the Ratings-Based Approach, Internal
Assessment Approach, or the Supervisory Formula Approach under sections
43, 44, and 45, respectively.
(3) Securitizations of non-IRB exposures. In accordance with
paragraphs (c) and (g)(3) of section 42, certain exposures to a
securitization any underlying exposure of which is not a wholesale
exposure, retail exposure, securitization exposure, or equity exposure.
(4) Low-rated securitization exposures. In accordance with section
43 and paragraph (c) of section 42, any securitization exposure that
qualifies for and must be deducted under the Ratings-Based Approach.
(5) High-risk securitization exposures subject to the Supervisory
Formula Approach. In accordance with paragraph (b) of section 45 and
paragraph (c) of section 42, any securitization exposure that qualifies
for the Supervisory Formula Approach and has a risk weight equal to
1,250 percent as calculated under the Supervisory Formula Approach.
(6) Eligible credit reserves shortfall. In accordance with
paragraph (a)(1) of section 13, any eligible credit reserves shortfall.
(7) Certain failed capital markets transactions. In accordance with
paragraph (e)(3) of section 35, the [bank]'s exposure on certain failed
capital markets transactions.
Section 12. Deductions and Limitations Not Required
(a) Deduction of CEIOs. A [bank] is not required to make the
deductions from capital for CEIOs in 12 CFR part 3, Appendix A, Sec.
2(c) (for national banks), 12 CFR part 208, Appendix A, Sec. II.B.1.e.
(for state member banks), 12 CFR part 225, Appendix A, Sec. II.B.1.e.
(for bank holding companies), 12 CFR part 325, Appendix A, Sec.
II.B.5. (for state nonmember banks), and 12 CFR 567.5(a)(2)(iii) and
567.12(e) (for savings associations).
(b) Deduction of certain equity investments. A [bank] is not
required to make the deductions from capital for nonfinancial equity
investments in 12 CFR part 3, Appendix A, Sec. 2(c) (for national
banks), 12 CFR part 208, Appendix A, Sec. II.B.5. (for state member
banks), 12 CFR part 225, Appendix A, Sec. II.B.5. (for bank holding
companies), and 12 CFR part 325, Appendix A, Sec. II.B. (for state
nonmember banks).
Section 13. Eligible Credit Reserves
(a) Comparison of eligible credit reserves to expected credit
losses--(1) Shortfall of eligible credit reserves. If a [bank]'s
eligible credit reserves are less than the [bank]'s total expected
credit losses, the [bank] must deduct the shortfall amount 50 percent
from tier 1 capital and 50 percent from tier 2 capital. If the amount
deductible from tier 2 capital exceeds the [bank]'s actual tier 2
capital, the [bank] must deduct the excess amount from tier 1 capital.
(2) Excess eligible credit reserves. If a [bank]'s eligible credit
reserves exceed the [bank]'s total expected credit losses, the [bank]
may include the excess amount in tier 2 capital to the extent that the
excess amount does not exceed 0.6 percent of the [bank]'s credit-risk-
weighted assets.
(b) Treatment of allowance for loan and lease losses. Regardless of
any provision to the contrary in [general risk-based capital rules],
ALLL is included in tier 2 capital only to the extent provided in
paragraph (a)(2) of this section and paragraph (b) of section 23.
Part III. Qualification
Section 21. Qualification Process
(a) Timing. (1) A [bank] that is described in paragraph (b)(1) of
section 1 must adopt a written implementation plan no later than six
months after the later of the effective date of this appendix or the
date the [bank] meets a criterion in that section. The plan must
incorporate an explicit first floor period
[[Page 55922]]
start date no later than 36 months after the later of the effective
date of this appendix or the date the [bank] meets at least one
criterion under paragraph (b)(1) of section 1. [AGENCY] may extend the
first floor period start date.
(2) A [bank] that elects to be subject to this appendix under
paragraph (b)(2) of section 1 must adopt a written implementation plan
and notify the [AGENCY] in writing of its intent at least 12 months
before it proposes to begin its first floor period.
(b) Implementation plan. The [bank]'s implementation plan must
address in detail how the [bank] complies, or plans to comply, with the
qualification requirements in section 22. The [bank] also must maintain
a comprehensive and sound planning and governance process to oversee
the implementation efforts described in the plan. At a minimum, the
plan must:
(1) Comprehensively address the qualification requirements in
section 22 for the [bank] and each consolidated subsidiary (U.S. and
foreign-based) of the [bank] with respect to all portfolios and
exposures of the [bank] and each of its consolidated subsidiaries;
(2) Justify and support any proposed temporary or permanent
exclusion of business lines, portfolios, or exposures from application
of the advanced approaches in this appendix (which business lines,
portfolios, and exposures must be, in the aggregate, immaterial to the
[bank]);
(3) Include the [bank]'s self-assessment of:
(i) The [bank]'s current status in meeting the qualification
requirements in section 22; and
(ii) The consistency of the [bank]'s current practices with the
[AGENCY]'s supervisory guidance on the qualification requirements;
(4) Based on the [bank]'s self-assessment, identify and describe
the areas in which the [bank] proposes to undertake additional work to
comply with the qualification requirements in section 22 or to improve
the consistency of the [bank]'s current practices with the [AGENCY]'s
supervisory guidance on the qualification requirements (gap analysis);
(5) Describe what specific actions the [bank] will take to address
the areas identified in the gap analysis required by paragraph (b)(4)
of this section;
(6) Identify objective, measurable milestones, including delivery
dates and a date when the [bank]'s implementation of the methodologies
described in this appendix will be fully operational;
(7) Describe resources that have been budgeted and are available to
implement the plan; and
(8) Receive board of directors approval.
(c) Parallel run. Before determining its risk-based capital
requirements under this appendix and following adoption of the
implementation plan, the [bank] must conduct a satisfactory parallel
run. A satisfactory parallel run is a period of no less than four
consecutive calendar quarters during which the [bank] complies with all
of the qualification requirements in section 22 to the satisfaction of
[AGENCY]. During the parallel run, the [bank] must report to the
[AGENCY] on a calendar quarterly basis its risk-based capital ratios
using [the general risk-based capital rules] and the risk-based capital
requirements described in this appendix. During this period, the [bank]
is subject to [the general risk-based capital rules].
(d) Approval to calculate risk-based capital requirements under
this appendix. The [AGENCY] will notify the [bank] of the date that the
[bank] may begin its first floor period following a determination by
the [AGENCY] that:
(1) The [bank] fully complies with the qualification requirements
in section 22;
(2) The [bank] has conducted a satisfactory parallel run under
paragraph (c) of this section; and
(3) The [bank] has an adequate process to ensure ongoing compliance
with the qualification requirements in section 22.
(e) Transitional floor periods. Following a satisfactory parallel
run, a [bank] is subject to three transitional floor periods.
(1) Risk-based capital ratios during the transitional floor
periods--(i) Tier 1 risk-based capital ratio. During a [bank]'s
transitional floor periods, a [bank]'s tier 1 risk-based capital ratio
is equal to the lower of:
(A) The [bank]'s floor-adjusted tier 1 risk-based capital ratio; or
(B) The [bank]'s advanced approaches tier 1 risk-based capital
ratio.
(ii) Total risk-based capital ratio. During a [bank]'s transitional
floor periods, a [bank]'s total risk-based capital ratio is equal to
the lower of:
(A) The [bank]'s floor-adjusted total risk-based capital ratio; or
(B) The [bank]'s advanced approaches total risk-based capital
ratio.
(2) Floor-adjusted risk-based capital ratios. (i) A [bank]'s floor-
adjusted tier 1 risk-based capital ratio during a transitional floor
period is equal to the [bank]'s tier 1 capital as calculated under [the
general risk-based capital rules], divided by the product of:
(A) The [bank]'s total risk-weighted assets as calculated under
[the general risk-based capital rules]; and
(B) The appropriate transitional floor percentage in Table 1.
(ii) A [bank]'s floor-adjusted total risk-based capital ratio
during a transitional floor period is equal to the sum of the [bank]'s
tier 1 and tier 2 capital as calculated under [the general risk-based
capital rules], divided by the product of:
(A) The [bank]'s total risk-weighted assets as calculated under
[the general risk-based capital rules]; and
(B) The appropriate transitional floor percentage in Table 1.
(iii) A [bank] that meets the criteria in paragraph (b)(1) or
(b)(2) of section 1 as of the effective date of this rule must use [the
general risk-based capital rules] effective immediately before this
rule became effective during the parallel run and as the basis for its
transitional floors.
Table 1--Transitional Floors
------------------------------------------------------------------------
Transitional floor
Transitional floor period percentage
------------------------------------------------------------------------
First floor period........................ 95 percent
Second floor period....................... 90 percent
Third floor period........................ 85 percent
------------------------------------------------------------------------
(3) Advanced approaches risk-based capital ratios. (i) A [bank]'s
advanced approaches tier 1 risk-based capital ratio equals the [bank]'s
tier 1 risk-based capital ratio as calculated under this appendix
(other than this section on transitional floor periods).
(ii) A [bank]'s advanced approaches total risk-based capital ratio
equals the [bank]'s total risk-based capital ratio as calculated under
this appendix (other than this section on transitional floor periods).
(4) Reporting. During the transitional floor periods, a [bank] must
report to the [AGENCY] on a calendar quarterly basis both floor-
adjusted risk-based capital ratios and both advanced approaches risk-
based capital ratios.
(5) Exiting a transitional floor period. A [bank] may not exit a
transitional floor period until the [bank] has spent a minimum of four
consecutive calendar quarters in the period and the [AGENCY] has
determined that the [bank] may exit the floor period. The [AGENCY]'s
determination will be based on an assessment of the [bank]'s ongoing
compliance with the qualification requirements in section 22.
Section 22. Qualification Requirements
(a) Process and systems requirements. (1) A [bank] must have a
rigorous process for assessing its overall capital adequacy in relation
to its risk profile
[[Page 55923]]
and a comprehensive strategy for maintaining an appropriate level of
capital.
(2) The systems and processes used by a [bank] for risk-based
capital purposes under this appendix must be consistent with the
[bank]'s internal risk management processes and management information
reporting systems.
(3) Each [bank] must have an appropriate infrastructure with risk
measurement and management processes that meet the qualification
requirements of this section and are appropriate given the [bank]'s
size and level of complexity. Regardless of whether the systems and
models that generate the risk parameters necessary for calculating a
[bank]'s risk-based capital requirements are located at any affiliate
of the [bank], the [bank] itself must ensure that the risk parameters
and reference data used to determine its risk-based capital
requirements are representative of its own credit risk and operational
risk exposures.
(b) Risk rating and segmentation systems for wholesale and retail
exposures. (1) A [bank] must have an internal risk rating and
segmentation system that accurately and reliably differentiates among
degrees of credit risk for the [bank]'s wholesale and retail exposures.
(2) For wholesale exposures, a [bank] must have an internal risk
rating system that accurately and reliably assigns each obligor to a
single rating grade (reflecting the obligor's likelihood of default).
The [bank]'s wholesale obligor rating system must have at least seven
discrete rating grades for non-defaulted obligors and at least one
rating grade for defaulted obligors. Unless the [bank] has chosen to
directly assign ELGD and LGD estimates to each wholesale exposure, the
[bank] must have an internal risk rating system that accurately and
reliably assigns each wholesale exposure to loss severity rating grades
(reflecting the [bank]'s estimate of the ELGD and LGD of the exposure).
A [bank] employing loss severity rating grades must have a sufficiently
granular loss severity grading system to avoid grouping together
exposures with widely ranging ELGDs or LGDs.
(3) For retail exposures, a [bank] must have a system that groups
exposures into segments with homogeneous risk characteristics and
assigns accurate and reliable PD, ELGD, and LGD estimates for each
segment on a consistent basis. The [bank]'s system must group retail
exposures into the appropriate retail exposure subcategory and must
group the retail exposures in each retail exposure subcategory into
separate segments. The [bank]'s system must identify all defaulted
retail exposures and group them in segments by subcategories separate
from non-defaulted retail exposures.
(4) The [bank]'s internal risk rating policy for wholesale
exposures must describe the [bank]'s rating philosophy (that is, must
describe how wholesale obligor rating assignments are affected by the
[bank]'s choice of the range of economic, business, and industry
conditions that are considered in the obligor rating process).
(5) The [bank]'s internal risk rating system for wholesale
exposures must provide for the review and update (as appropriate) of
each obligor rating and (if applicable) each loss severity rating
whenever the [bank] receives new material information, but no less
frequently than annually. The [bank]'s retail exposure segmentation
system must provide for the review and update (as appropriate) of
assignments of retail exposures to segments whenever the [bank]
receives new material information, but no less frequently than
quarterly.
(c) Quantification of risk parameters for wholesale and retail
exposures. (1) The [bank] must have a comprehensive risk parameter
quantification process that produces accurate, timely, and reliable
estimates of the risk parameters for the [bank]'s wholesale and retail
exposures.
(2) Data used to estimate the risk parameters must be relevant to
the [bank]'s actual wholesale and retail exposures, and of sufficient
quality to support the determination of risk-based capital requirements
for the exposures.
(3) The [bank]'s risk parameter quantification process must produce
conservative risk parameter estimates where the [bank] has limited
relevant data, and any adjustments that are part of the quantification
process must not result in a pattern of bias toward lower risk
parameter estimates.
(4) PD estimates for wholesale and retail exposures must be based
on at least 5 years of default data. ELGD and LGD estimates for
wholesale exposures must be based on at least 7 years of loss severity
data, and ELGD and LGD estimates for retail exposures must be based on
at least 5 years of loss severity data. EAD estimates for wholesale
exposures must be based on at least 7 years of exposure amount data,
and EAD estimates for retail exposures must be based on at least 5
years of exposure amount data.
(5) Default, loss severity, and exposure amount data must include
periods of economic downturn conditions, or the [bank] must adjust its
estimates of risk parameters to compensate for the lack of data from
periods of economic downturn conditions.
(6) The [bank]'s PD, ELGD, LGD, and EAD estimates must be based on
the definition of default in this appendix.
(7) The [bank] must review and update (as appropriate) its risk
parameters and its risk parameter quantification process at least
annually.
(8) The [bank] must at least annually conduct a comprehensive
review and analysis of reference data to determine relevance of
reference data to [bank] exposures, quality of reference data to
support PD, ELGD, LGD, and EAD estimates, and consistency of reference
data to the definition of default contained in this appendix.
(d) Counterparty credit risk model. A [bank] must obtain the prior
written approval of [AGENCY] under section 32 to use the internal
models methodology for counterparty credit risk.
(e) Double default treatment. A [bank] must obtain the prior
written approval of [AGENCY] under section 34 to use the double default
treatment.
(f) Securitization exposures. A [bank] must obtain the prior
written approval of [AGENCY] under section 44 to use the internal
assessment approach for securitization exposures to ABCP programs.
(g) Equity exposures model. A [bank] must obtain the prior written
approval of [AGENCY] under section 53 to use the internal models
approach for equity exposures.
(h) Operational risk--(1) Operational risk management processes. A
[bank] must:
(i) Have an operational risk management function that:
(A) Is independent of business line management; and
(B) Is responsible for designing, implementing, and overseeing the
[bank]'s operational risk data and assessment systems, operational risk
quantification systems, and related processes;
(ii) Have and document a process to identify, measure, monitor, and
control operational risk in [bank] products, activities, processes, and
systems (which process must capture business environment and internal
control factors affecting the [bank]'s operational risk profile); and
(iii) Report operational risk exposures, operational loss events,
and other relevant operational risk information to business unit
management, senior management, and the board of directors (or a
designated committee of the board).
(2) Operational risk data and assessment systems. A [bank] must
have
[[Page 55924]]
operational risk data and assessment systems that capture operational
risks to which the [bank] is exposed. The [bank]'s operational risk
data and assessment systems must:
(i) Be structured in a manner consistent with the [bank]'s current
business activities, risk profile, technological processes, and risk
management processes; and
(ii) Include credible, transparent, systematic, and verifiable
processes that incorporate the following elements on an ongoing basis:
(A) Internal operational loss event data. The [bank] must have a
systematic process for capturing and using internal operational loss
event data in its operational risk data and assessment systems.
(1) The [bank]'s operational risk data and assessment systems must
include an historical observation period of at least five years for
internal operational loss event data (or such shorter period approved
by [AGENCY] to address transitional situations, such as integrating a
new business line).
(2) The [bank] may refrain from collecting internal operational
loss event data for individual operational losses below established
dollar threshold amounts if the [bank] can demonstrate to the
satisfaction of the [AGENCY] that the thresholds are reasonable, do not
exclude important internal operational loss event data, and permit the
[bank] to capture substantially all the dollar value of the [bank]'s
operational losses.
(B) External operational loss event data. The [bank] must have a
systematic process for determining its methodologies for incorporating
external operational loss data into its operational risk data and
assessment systems.
(C) Scenario analysis. The [bank] must have a systematic process
for determining its methodologies for incorporating scenario analysis
into its operational risk data and assessment systems.
(D) Business environment and internal control factors. The [bank]
must incorporate business environment and internal control factors into
its operational risk data and assessment systems. The [bank] must also
periodically compare the results of its prior business environment and
internal control factor assessments against its actual operational
losses incurred in the intervening period.
(3) Operational risk quantification systems. (i) The [bank]'s
operational risk quantification systems:
(A) Must generate estimates of the [bank]'s operational risk
exposure using its operational risk data and assessment systems; and
(B) Must employ a unit of measure that is appropriate for the
[bank]'s range of business activities and the variety of operational
loss events to which it is exposed, and that does not combine business
activities or operational loss events with different risk profiles
within the same loss distribution.
(C) May use internal estimates of dependence among operational
losses within and across business lines and operational loss events if
the [bank] can demonstrate to the satisfaction of [AGENCY] that its
process for estimating dependence is sound, robust to a variety of
scenarios, and implemented with integrity, and allows for the
uncertainty surrounding the estimates. If the [bank] has not made such
a demonstration, it must sum operational risk exposure estimates across
units of measure to calculate its total operational risk exposure.
(D) Must be reviewed and updated (as appropriate) whenever the
[bank] becomes aware of information that may have a material effect on
the [bank]'s estimate of operational risk exposure, but no less
frequently than annually.
(ii) With the prior written approval of [AGENCY], a [bank] may
generate an estimate of its operational risk exposure using an
alternative approach to that specified in paragraph (h)(3)(i) of this
section. A [bank] proposing to use such an alternative operational risk
quantification system must submit a proposal to [AGENCY]. In
considering a [bank]'s proposal to use an alternative operational risk
quantification system, [AGENCY] will consider the following principles:
(A) Use of the alternative operational risk quantification system
will be allowed only on an exception basis, considering the size,
complexity, and risk profile of a [bank];
(B) The [bank] must demonstrate that its estimate of its
operational risk exposure generated under the alternative operational
risk quantification system is appropriate and can be supported
empirically; and
(C) A [bank] must not use an allocation of operational risk capital
requirements that includes entities other than depository institutions
or the benefits of diversification across entities.
(i) Data management and maintenance. (1) A [bank] must have data
management and maintenance systems that adequately support all aspects
of its advanced systems and the timely and accurate reporting of risk-
based capital requirements.
(2) A [bank] must retain data using an electronic format that
allows timely retrieval of data for analysis, validation, reporting,
and disclosure purposes.
(3) A [bank] must retain sufficient data elements related to key
risk drivers to permit adequate monitoring, validation, and refinement
of its advanced systems.
(j) Control, oversight, and validation mechanisms. (1) The [bank]'s
senior management must ensure that all components of the [bank]'s
advanced systems function effectively and comply with the qualification
requirements in this section.
(2) The [bank]'s board of directors (or a designated committee of
the board) must at least annually evaluate the effectiveness of, and
approve, the [bank]'s advanced systems.
(3) A [bank] must have an effective system of controls and
oversight that:
(i) Ensures ongoing compliance with the qualification requirements
in this section;
(ii) Maintains the integrity, reliability, and accuracy of the
[bank]'s advanced systems; and
(iii) Includes adequate governance and project management
processes.
(4) The [bank] must validate, on an ongoing basis, its advanced
systems. The [bank]'s validation process must be independent of the
advanced systems' development, implementation, and operation, or the
validation process must be subjected to an independent review of its
adequacy and effectiveness. Validation must include:
(i) The evaluation of the conceptual soundness of (including
developmental evidence supporting) the advanced systems;
(ii) An on-going monitoring process that includes verification of
processes and benchmarking; and
(iii) An outcomes analysis process that includes back-testing.
(5) The [bank] must have an internal audit function independent of
business-line management that at least annually assesses the
effectiveness of the controls supporting the [bank]'s advanced systems
and reports its findings to the [bank]'s board of directors (or a
committee thereof).
(6) The [bank] must periodically stress test its advanced systems.
The stress testing must include a consideration of how economic cycles,
especially downturns, affect risk-based capital requirements (including
migration across rating grades and segments and the credit risk
mitigation benefits of double default treatment).
(k) Documentation. The [bank] must adequately document all material
aspects of its advanced systems.
[[Page 55925]]
Section 23. Ongoing Qualification
(a) Changes to advanced systems. A [bank] must meet all the
qualification requirements in section 22 on an ongoing basis. A [bank]
must notify the [AGENCY] when the [bank] makes any change to an
advanced system that would result in a material change in the [bank]'s
risk-weighted asset amount for an exposure type, or when the [bank]
makes any significant change to its modeling assumptions.
(b) Mergers and acquisitions--(1) Mergers and acquisitions of
companies without advanced systems. If a [bank] merges with or acquires
a company that does not calculate its risk-based capital requirements
using advanced systems, the [bank] may use [the general risk-based
capital rules] to determine the risk-weighted asset amounts for, and
deductions from capital associated with, the merged or acquired
company's exposures for up to 24 months after the calendar quarter
during which the merger or acquisition consummates. [AGENCY] may extend
this transition period for up to an additional 12 months. Within 30
days of consummating the merger or acquisition, the [bank] must submit
to [AGENCY] an implementation plan for using its advanced systems for
the acquired company. During the period when [the general risk-based
capital rules] apply to the merged or acquired company, any ALLL, net
of allocated transfer risk reserves established pursuant to 12 U.S.C.
3904, associated with the merged or acquired company's exposures may be
included in the [bank]'s tier 2 capital up to 1.25 percent of the
acquired company's risk-weighted assets. All general reserves of the
merged or acquired company must be excluded from the [bank]'s eligible
credit reserves. In addition, the risk-weighted assets of the merged or
acquired company are not included in the [bank]'s credit-risk-weighted
assets but are included in total risk-weighted assets. If a [bank]
relies on this paragraph, the [bank] must disclose publicly the amounts
of risk-weighted assets and qualifying capital calculated under this
appendix for the acquiring [bank] and under [the general risk-based
capital rules] for the acquired company.
(2) Mergers and acquisitions of companies with advanced systems. If
a [bank] merges with or acquires a company that calculates its risk-
based capital requirements using advanced systems, the acquiring [bank]
may use the acquired company's advanced systems to determine the risk-
weighted asset amounts for, and deductions from capital associated
with, the merged or acquired company's exposures for up to 24 months
after the calendar quarter during which the acquisition or merger
consummates. [AGENCY] may extend this transition period for up to an
additional 12 months. Within 30 days of consummating the merger or
acquisition, the [bank] must submit to [AGENCY] an implementation plan
for using its advanced systems for the merged or acquired company.
(c) Failure to comply with qualification requirements. If [AGENCY]
determines that a [bank] that is subject to this appendix and has
conducted a satisfactory parallel run fails to comply with the
qualification requirements in section 22, [AGENCY] will notify the
[bank] in writing of the [bank]'s failure to comply. The [bank] must
establish a plan satisfactory to the [AGENCY] to return to compliance
with the qualification requirements and must disclose to the public its
failure to comply with the qualification requirements promptly after
receiving notice from the [AGENCY]. In addition, if the [AGENCY]
determines that the [bank]'s risk-based capital requirements are not
commensurate with the [bank]'s credit, market, operational, or other
risks, the [AGENCY] may require such a [bank] to calculate its risk-
based capital requirements:
(1) Under [the general risk-based capital rules]; or
(2) Under this appendix with any modifications provided by the
[AGENCY].
Part IV. Risk-Weighted Assets for General Credit Risk
Section 31. Mechanics for Calculating Total Wholesale and Retail Risk-
Weighted Assets
(a) Overview. A [bank] must calculate its total wholesale and
retail risk-weighted asset amount in four distinct phases:
(1) Phase 1--categorization of exposures;
(2) Phase 2--assignment of wholesale obligors and exposures to
rating grades and segmentation of retail exposures;
(3) Phase 3--assignment of risk parameters to wholesale exposures
and segments of retail exposures; and
(4) Phase 4--calculation of risk-weighted asset amounts.
(b) Phase 1--Categorization. The [bank] must determine which of its
exposures are wholesale exposures, retail exposures, securitization
exposures, or equity exposures. The [bank] must categorize each retail
exposure as a residential mortgage exposure, a QRE, or an other retail
exposure. The [bank] must identify which wholesale exposures are HVCRE
exposures, sovereign exposures, OTC derivative contracts, repo-style
transactions, eligible margin loans, eligible purchased wholesale
receivables, unsettled transactions to which section 35 applies, and
eligible guarantees or eligible credit derivatives that are used as
credit risk mitigants. The [bank] must identify any on-balance sheet
asset that does not meet the definition of a wholesale, retail, equity,
or securitization exposure, as well as any non-material portfolio of
exposures described in paragraph (e)(4) of this section.
(c) Phase 2--Assignment of wholesale obligors and exposures to
rating grades and retail exposures to segments--(1) Assignment of
wholesale obligors and exposures to rating grades.
(i) The [bank] must assign each obligor of a wholesale exposure to
a single obligor rating grade and may assign each wholesale exposure to
loss severity rating grades.
(ii) The [bank] must identify which of its wholesale obligors are
in default.
(2) Segmentation of retail exposures. (i) The [bank] must group the
retail exposures in each retail subcategory into segments that have
homogeneous risk characteristics.
(ii) The [bank] must identify which of its retail exposures are in
default. The [bank] must segment defaulted retail exposures separately
from non-defaulted retail exposures.
(iii) If the [bank] determines the EAD for eligible margin loans
using the approach in paragraph (a) of section 32, the [bank] must
identify which of its retail exposures are eligible margin loans for
which the [bank] uses this EAD approach and must segment such eligible
margin loans separately from other retail exposures.
(3) Eligible purchased wholesale receivables. A [bank] may group
its eligible purchased wholesale receivables that, when consolidated by
obligor, total less than $1 million into segments that have homogeneous
risk characteristics. A [bank] must use the wholesale exposure formula
in Table 2 in this section to determine the risk-based capital
requirement for each segment of eligible purchased wholesale
receivables.
(d) Phase 3--Assignment of risk parameters to wholesale exposures
and segments of retail exposures--(1) Quantification process. Subject
to the limitations in this paragraph (d), the [bank] must:
(i) Associate a PD with each wholesale obligor rating grade;
(ii) Associate an ELGD or LGD, as appropriate, with each wholesale
loss
[[Page 55926]]
severity rating grade or assign an ELGD and LGD to each wholesale
exposure;
(iii) Assign an EAD and M to each wholesale exposure; and
(iv) Assign a PD, ELGD, LGD, and EAD to each segment of retail
exposures.
(2) Floor on PD assignment. The PD for each wholesale exposure or
retail segment may not be less than 0.03 percent, except for exposures
to or directly and unconditionally guaranteed by a sovereign entity,
the Bank for International Settlements, the International Monetary
Fund, the European Commission, the European Central Bank, or a multi-
lateral development bank, to which the [bank] assigns a rating grade
associated with a PD of less than 0.03 percent.
(3) Floor on LGD estimation. The LGD for each segment of
residential mortgage exposures (other than segments of residential
mortgage exposures for which all or substantially all of the principal
of each exposure is directly and unconditionally guaranteed by the full
faith and credit of a sovereign entity) may not be less than 10
percent.
(4) Eligible purchased wholesale receivables. A [bank] must assign
a PD, ELGD, LGD, EAD, and M to each segment of eligible purchased
wholesale receivables. If the [bank] can estimate ECL (but not PD or
LGD) for a segment of eligible purchased wholesale receivables, the
[bank] must assume that the ELGD and LGD of the segment equals 100
percent and that the PD of the segment equals ECL divided by EAD. The
estimated ECL must be calculated for the receivables without regard to
any assumption of recourse or guarantees from the seller or other
parties.
(5) Credit risk mitigation--credit derivatives, guarantees, and
collateral. (i) A [bank] may take into account the risk reducing
effects of eligible guarantees and eligible credit derivatives in
support of a wholesale exposure by applying the PD substitution or LGD
adjustment treatment to the exposure as provided in section 33 or, if
applicable, applying double default treatment to the exposure as
provided in section 34. A [bank] may decide separately for each
wholesale exposure that qualifies for the double default treatment
under section 34 whether to apply the double default treatment or to
use the PD substitution or LGD adjustment approach without recognizing
double default effects.
(ii) A [bank] may take into account the risk reducing effects of
guarantees and credit derivatives in support of retail exposures in a
segment when quantifying the PD, ELGD, and LGD of the segment.
(iii) Except as provided in paragraph (d)(6) of this section, a
[bank] may take into account the risk reducing effects of collateral in
support of a wholesale exposure when quantifying the ELGD and LGD of
the exposure and may take into account the risk reducing effects of
collateral in support of retail exposures when quantifying the PD,
ELGD, and LGD of the segment.
(6) EAD for derivative contracts, repo-style transactions, and
eligible margin loans. (i) A [bank] must calculate its EAD for an OTC
derivative contract as provided in paragraphs (b) and (c) of section
32. A [bank] may take into account the risk-reducing effects of
financial collateral in support of a repo-style transaction or eligible
margin loan through an adjustment to EAD as provided in paragraphs (a)
and (c) of section 32. A [bank] that takes financial collateral into
account through such an adjustment to EAD under section 32 may not
adjust ELGD or LGD to reflect the financial collateral.
(ii) A [bank] may attribute an EAD of zero to:
(A) Derivative contracts that are publicly traded on an exchange
that requires the daily receipt and payment of cash-variation margin;
(B) Derivative contracts and repo-style transactions that are
outstanding with a qualifying central counterparty (but not for those
transactions that a qualifying central counterparty has rejected); and
(C) Credit risk exposures to a qualifying central counterparty in
the form of clearing deposits and posted collateral that arise from
transactions described in paragraph (d)(6)(ii)(B) of this section.
(7) Effective maturity. An exposure's M must be no greater than
five years and no less than one year, except that a [bank] may set the
M of an exposure equal to the greater of one day or M if the exposure
has an original maturity of less than one year and is not part of the
[bank]'s ongoing financing of the obligor. An exposure is not part of a
[bank]'s ongoing financing of the obligor if the [bank]:
(i) Has a legal and practical ability not to renew or roll over the
exposure in the event of credit deterioration of the obligor;
(ii) Makes an independent credit decision at the inception of the
exposure and at every renewal or roll over; and
(iii) Has no substantial commercial incentive to continue its
credit relationship with the obligor in the event of credit
deterioration of the obligor.
(e) Phase 4--Calculation of risk-weighted assets--(1) Non-defaulted
exposures. (i) A [bank] must calculate the dollar risk-based capital
requirement for each of its wholesale exposures to a non-defaulted
obligor and segments of non-defaulted retail exposures (except eligible
guarantees and eligible credit derivatives that hedge another wholesale
exposure and exposures to which the [bank] applies the double default
treatment in section 34) by inserting the assigned risk parameters for
the wholesale obligor and exposure or retail segment into the
appropriate risk-based capital formula specified in Table 2 and
multiplying the output of the formula (K) by the EAD of the exposure or
segment.\7\
---------------------------------------------------------------------------
\7\ A [bank] may instead apply a 300 percent risk weight to the
EAD of an eligible margin loan if the [bank] is not able to assign a
rating grade to the obligor of the loan.
---------------------------------------------------------------------------
[[Page 55927]]
[GRAPHIC] [TIFF OMITTED] TP25SE06.080
(ii) The sum of all of the dollar risk-based capital requirements
for each wholesale exposure to a non-defaulted obligor and segment of
non-defaulted retail exposures calculated in paragraph (e)(1)(i) of
this section and in paragraph (e) of section 34 equals the total dollar
risk-based capital requirement for those exposures and segments.
(iii) The aggregate risk-weighted asset amount for wholesale
exposures to non-defaulted obligors and segments of non-defaulted
retail exposures equals the total dollar risk-based capital requirement
calculated in paragraph (e)(1)(ii) of this section multiplied by 12.5.
(2) Wholesale exposures to defaulted obligors and segments of
defaulted retail exposures--(i) Wholesale exposures to defaulted
obligors.
(A) For each wholesale exposure to a defaulted obligor, the [bank]
must compare:
(1) 0.08 multiplied by the EAD of the wholesale exposure, plus the
amount of any charge-offs or write-downs on the exposure; and
(2) K for the wholesale exposure (as determined in Table 2
immediately before the obligor became defaulted), multiplied by the EAD
of the wholesale exposure immediately before the obligor became
defaulted.
(B) If the amount calculated in paragraph (e)(2)(i)(A)1 is equal to
or greater than the amount calculated in paragraph (e)(2)(i)(A)2, the
dollar risk-based capital requirement for the exposure is 0.08
multiplied by the EAD of the wholesale exposure.
(C) If the amount calculated in paragraph (e)(2)(i)(A)1 is less
than the amount calculated in paragraph (e)(2)(i)(A)2, the dollar risk-
based capital requirement for the exposure is K for the wholesale
exposure (as determined in Table 2 immediately before the obligor
became defaulted) multiplied by the EAD of the wholesale exposure.
(ii) Segments of defaulted retail exposures. The dollar risk-based
capital requirement for a segment of defaulted retail exposures equals
0.08 multiplied by the EAD of the segment.
(iii) The sum of all the dollar risk-based capital requirements for
each wholesale exposure to a defaulted obligor calculated in paragraphs
(e)(2)(i)(B) and (C) of this section plus the dollar risk-based capital
requirements for each segment of defaulted retail exposures calculated
in paragraph (e)(2)(ii) of this section equals the total dollar risk-
based capital requirement for those exposures.
(iv) The aggregate risk-weighted asset amount for wholesale
exposures to defaulted obligors and segments of defaulted retail
exposures equals the total dollar risk-based capital requirement
calculated in paragraph
[[Page 55928]]
(e)(2)(iii) of this section multiplied by 12.5.
(3) Assets not included in a defined exposure category. A [bank]
may assign a risk-weighted asset amount of zero to cash owned and held
in all offices of the [bank] or in transit and for gold bullion held in
the [bank]'s own vaults, or held in another [bank]'s vaults on an
allocated basis, to the extent it is offset by gold bullion
liabilities. The risk-weighted asset amount for the residual value of a
retail lease exposure equals such residual value. The risk-weighted
asset amount for an excluded mortgage exposure is determined under 12
CFR part 3, Appendix A, section 3(a)(3)(iii) (for national banks), 12
CFR part 208, Appendix A, section III.C.3. (for state member banks), 12
CFR part 225, Appendix A, section III.C.3. (for bank holding
companies), 12 CFR part 325, Appendix A, section II.C.a. (for state
nonmember banks), and 12 CFR 567.6(a)(1)(iii) and (iv) (for savings
associations). The risk-weighted asset amount for any other on-balance-
sheet asset that does not meet the definition of a wholesale, retail,
securitization, or equity exposure equals the carrying value of the
asset.
(4) Non-material portfolios of exposures. The risk-weighted asset
amount of a portfolio of exposures for which the [bank] has
demonstrated to [AGENCY]'s satisfaction that the portfolio (when
combined with all other portfolios of exposures that the [bank] seeks
to treat under this paragraph) is not material to the [bank] is the sum
of the carrying values of on-balance sheet exposures plus the notional
amounts of off-balance sheet exposures in the portfolio. For purposes
of this paragraph (e)(4), the notional amount of an OTC derivative
contract that is not a credit derivative is the EAD of the derivative
as calculated in section 32.
Section 32. Counterparty Credit Risk
This section describes two methodologies--a collateral haircut
approach and an internal models methodology--that a [bank] may use
instead of an ELGD/LGD estimation methodology to recognize the benefits
of financial collateral in mitigating the counterparty credit risk of
repo-style transactions, eligible margin loans, and collateralized OTC
derivative contracts, and single product netting sets of such
transactions. A third methodology, the simple VaR methodology, is
available for single product netting sets of repo-style transactions
and eligible margin loans. This section also describes the methodology
for calculating EAD for an OTC derivative contract or a set of OTC
derivative contracts subject to a qualifying master netting agreement.
A [bank] also may use the internal models methodology to estimate EAD
for qualifying cross-product master netting agreements.
A [bank] may use any combination of the three methodologies for
collateral recognition; however, it must use the same methodology for
similar exposures. A [bank] may use separate methodologies for agency
securities lending transactions--that is, securities lending
transactions in which the [bank], acting as agent for a customer, lends
the customer's securities and indemnifies the customer against loss--
and all other repo-style transactions.
(a) EAD for eligible margin loans and repo-style transactions--(1)
General. A [bank] may recognize the credit risk mitigation benefits of
financial collateral that secures an eligible margin loan, repo-style
transaction, or single-product group of such transactions with a single
counterparty subject to a qualifying master netting agreement (netting
set) by factoring the collateral into its ELGD and LGD estimates for
the exposure. Alternatively, a [bank] may estimate an unsecured ELGD
and LGD for the exposure and determine the EAD of the exposure using:
(i) The collateral haircut approach described in paragraph (a)(2)
of this section;
(ii) For netting sets only, the simple VaR methodology described in
paragraph (a)(3) of this section; or
(iii) The internal models methodology described in paragraph (c) of
this section.
(2) Collateral haircut approach--(i) EAD equation. A [bank] may
determine EAD for an eligible margin loan, repo-style transaction, or
netting set by setting EAD = max {0, [([Sigma]E - [Sigma]C) +
[Sigma](Es x Hs) + (Efx x Hfx)]{time} , where:
(A) [Sigma]E equals the value of the exposure (that is, the sum of
the current market values of all securities and cash the [bank] has
lent, sold subject to repurchase, or posted as collateral to the
counterparty under the transaction (or netting set));
(B) [Sigma]C equals the value of the collateral (that is, the sum
of the current market values of all securities and cash the [bank] has
borrowed, purchased subject to resale, or taken as collateral from the
counterparty under the transaction (or netting set));
(C) Es = absolute value of the net position in a given security
(where the net position in a given security equals the sum of the
current market values of the particular security the [bank] has lent,
sold subject to repurchase, or posted as collateral to the counterparty
minus the sum of the current market values of that same security the
[bank] has borrowed, purchased subject to resale, or taken as
collateral from the counterparty);
(D) Hs = market price volatility haircut appropriate to the
security referenced in Es;
(E) Efx = absolute value of the net position of both cash and
securities in a currency that is different from the settlement currency
(where the net position in a given currency equals the sum of the
current market values of any cash or securities in the currency the
[bank] has lent, sold subject to repurchase, or posted as collateral to
the counterparty minus the sum of the current market values of any cash
or securities in the currency the [bank] has borrowed, purchased
subject to resale, or taken as collateral from the counterparty); and
(F) Hfx = haircut appropriate to the mismatch between the currency
referenced in Efx and the settlement currency.
(ii) Standard supervisory haircuts. (A) Under the ``standard
supervisory haircuts'' approach:
(1) A [bank] must use the haircuts for market price volatility (Hs)
in Table 3, as adjusted in certain circumstances as provided in
paragraph (a)(2)(ii)(A)(3) and (4) of this section;
Table 3.--Standard Supervisory Market Price Volatility Haircuts*
----------------------------------------------------------------------------------------------------------------
Issuers exempt
Applicable external rating grade category for Residual maturity for debt from the 3 Other issuers
debt securities securities b.p. floor
----------------------------------------------------------------------------------------------------------------
Two highest investment grade rating categories <=1 year........................ .005 .01
for long-term ratings/highest investment >1 year, <=5 years.............. .02 .04
grade rating category for short-term ratings. >5 years........................ .04 .08
----------------------------------------------------------------------------------------------------------------
[[Page 55929]]
Two lowest investment grade ratiing categories <=1 year........................ .01 .02
for both short- and long-term ratings. >1 year, <=5 years.............. .03 .06
>5 years........................ .06 .12
----------------------------------------------------------------------------------------------------------------
One rating category below investment grade.... All............................. .15 .25
----------------------------------------------------------------------------------------------------------------
Main index equities (including convertible bonds) and gold..............15......
----------------------------------------------------------------------------------------------------------------
Other publicly traded equities (including convertible bonds)............25......
----------------------------------------------------------------------------------------------------------------
Mutual funds......................................Highest haircut applicable to any security in
which the fund can invest.
----------------------------------------------------------------------------------------------------------------
Cash on deposit with the [bank] (including a certificate of deposit issu0d by
the [bank]).
----------------------------------------------------------------------------------------------------------------
*The market price volatility haircuts in Table 3 are based on a 10-business-day holding period.
(2) For currency mismatches, a [bank] must use a haircut for
foreign exchange rate volatility (Hfx) of 8 percent, as adjusted in
certain circumstances as provided in paragraph (a)(2)(ii)(A)(3) and (4)
of this section.
(3) For repo-style transactions, a [bank] may multiply the
supervisory haircuts provided in paragraphs (a)(2)(ii)(A)(1) and (2) by
the square root of \1/2\ (which equals 0.707107).
(4) A [bank] must adjust the supervisory haircuts upward on the
basis of a holding period longer than 10 business days (for eligible
margin loans) or 5 business days (for repo-style transactions) where
and as appropriate to take into account the illiquidity of an
instrument.
(iii) Own estimates for haircuts. With the prior written approval
of [AGENCY], a [bank] may calculate haircuts (Hs and Hfx) using its own
internal estimates of the volatilities of market prices and foreign
exchange rates.
(A) To receive [AGENCY] approval to use internal estimates, a
[bank] must satisfy the following minimum quantitative standards:
(1) A [bank] must use a 99th percentile one-tailed confidence
interval.
(2) The minimum holding period for a repo-style transaction is 5
business days and for an eligible margin loan is 10 business days. When
a [bank] calculates an own-estimates haircut on a TN-day
holding period, which is different from the minimum holding period for
the transaction type, the applicable haircut (HM) is
calculated using the following square root of time formula:
[GRAPHIC] [TIFF OMITTED] TP25SE06.058
(i) TM = 5 for repo-style transactions and 10 for
eligible margin loans;
(ii) TN = holding period used by the [bank] to derive
HN; and
(iii) HN = haircut based on the holding period
TN.
(3) A [bank] must adjust holding periods upwards where and as
appropriate to take into account the illiquidity of an instrument.
(4) The historical observation period must be at least one year.
(5) A [bank] must update its data sets and recompute haircuts no
less frequently than quarterly and must also reassess data sets and
haircuts whenever market prices change materially.
(B) With respect to debt securities that have an applicable
external rating of investment grade, a [bank] may calculate haircuts
for categories of securities. For a category of securities, the [bank]
must calculate the haircut on the basis of internal volatility
estimates for securities in that category that are representative of
the securities in that category that the [bank] has actually lent, sold
subject to repurchase, posted as collateral, borrowed, purchased
subject to resale, or taken as collateral. In determining relevant
categories, the [bank] must take into account:
(1) The type of issuer of the security;
(2) The applicable external rating of the security;
(3) The maturity of the security; and
(4) The interest rate sensitivity of the security.
(C) With respect to debt securities that have an applicable
external rating of below investment grade and equity securities, a
[bank] must calculate a separate haircut for each individual security.
(D) Where an exposure or collateral (whether in the form of cash or
securities) is denominated in a currency that differs from the
settlement currency, the [bank] must calculate a separate currency
mismatch haircut for its net position in each mismatched currency based
on estimated volatilities of foreign exchange rates between the
mismatched currency and the settlement currency.
(E) A [bank]'s own estimates of market price and foreign exchange
rate volatilities may not take into account the correlations among
securities and foreign exchanges rates on either the exposure or
collateral side of a transaction (or netting set) or the correlations
among securities and foreign exchange rates between the exposure and
collateral sides of the transaction (or netting set).
(3) Simple VaR methodology. With the prior written approval of
[AGENCY], a [bank] may estimate EAD for a netting set using a VaR model
that meets the requirements in paragraph (a)(3)(iii) of this section.
In such event, the [bank] must set EAD = max {0, [([Sigma]E - [Sigma]C)
+ PFE]{time} , where:
[[Page 55930]]
(i) [Sigma]E equals the value of the exposure (that is, the sum of
the current market values of all securities and cash the [bank] has
lent, sold subject to repurchase, or posted as collateral to the
counterparty under the netting set);
(ii) [Sigma]C equals the value of the collateral (that is, the sum
of the current market values of all securities and cash the [bank] has
borrowed, purchased subject to resale, or taken as collateral from the
counterparty under the netting set); and
(iii) PFE (potential future exposure) equals the [bank]'s
empirically-based best estimate of the 99th percentile, one-tailed
confidence interval for an increase in the value of ([Sigma]E -
[Sigma]C) over a 5-business-day holding period for repo-style
transactions or over a 10-business-day holding period for eligible
margin loans using a minimum one-year historical observation period of
price data representing the instruments that the [bank] has lent, sold
subject to repurchase, posted as collateral, borrowed, purchased
subject to resale, or taken as collateral. The [bank] must validate its
VaR model, including by establishing and maintaining a rigorous and
regular back-testing regime.
(b) EAD for OTC derivative contracts. (1) A [bank] must determine
the EAD for an OTC derivative contract that is not subject to a
qualifying master netting agreement using the current exposure
methodology in paragraph (b)(5) of this section or using the internal
models methodology described in paragraph (c) of this section.
(2) A [bank] must determine the EAD for multiple OTC derivative
contracts that are subject to a qualifying master netting agreement
using the current exposure methodology in paragraph (b)(6) of this
section or using the internal models methodology described in paragraph
(c) of this section.\8\
---------------------------------------------------------------------------
\8\ For purposes of this determination, for OTC derivative
contracts, a [bank] must maintain a written and well reasoned legal
opinion that this agreement meets the criteria set forth in the
definition of qualifying master netting agreement.
---------------------------------------------------------------------------
(3) Counterparty credit risk for credit derivatives.
Notwithstanding the above,
(i) A [bank] that purchases a credit derivative that is recognized
under section 33 or 34 as a credit risk mitigant for an exposure that
is not a covered position under [the market risk rule] need not compute
a separate counterparty credit risk capital requirement under this
section so long as it does so consistently for all such credit
derivatives and either includes all or excludes all such credit
derivatives that are subject to a master netting contract from any
measure used to determine counterparty credit risk exposure to all
relevant counterparties for risk-based capital purposes.
(ii) A [bank] that is the protection provider in a credit
derivative must treat the credit derivative as a wholesale exposure to
the reference obligor and need not compute a counterparty credit risk
capital requirement for the credit derivative under this section, so
long as it does so consistently for all such credit derivatives and
either includes all or excludes all such credit derivatives that are
subject to a master netting contract from any measure used to determine
counterparty credit risk exposure to all relevant counterparties for
risk-based capital purposes (unless the [bank] is treating the credit
derivative as a covered position under [the market risk rule], in which
case the [bank] must compute a supplemental counterparty credit risk
capital requirement under this section).
(4) Counterparty credit risk for equity derivatives. A [bank] must
treat an equity derivative contract as an equity exposure and compute a
risk-weighted asset amount for the equity derivative contract under
part VI (unless the [bank] is treating the contract as a covered
position under [the market risk rule]). In addition, if the [bank] is
treating the contract as a covered position under [the market risk
rule] and in certain other cases described in section 55, the [bank]
must also calculate a risk-based capital requirement for the
counterparty credit risk of an equity derivative contract under this
part.
(5) Single OTC derivative contract. Except as modified by paragraph
(b)(7) of this section, the EAD for a single OTC derivative contract
that is not subject to a qualifying master netting agreement is equal
to the sum of the [bank]'s current credit exposure and potential future
credit exposure on the derivative contract.
(i) Current credit exposure. The current credit exposure for a
single OTC derivative contract is the greater of the mark-to-market
value of the derivative contract or zero.
(ii) PFE. The PFE for a single OTC derivative contract, including
an OTC derivative contract with a negative mark-to-market value, is
calculated by multiplying the notional principal amount of the
derivative contract by the appropriate conversion factor in Table 4.
For purposes of calculating either the potential future credit exposure
under this paragraph or the gross potential future credit exposure
under paragraph (b)(6) of this section for exchange rate contracts and
other similar contracts in which the notional principal amount is
equivalent to the cash flows, notional principal amount is the net
receipts to each party falling due on each value date in each currency.
For any OTC derivative contract that does not fall within one of the
specified categories in Table 4, the potential future credit exposure
must be calculated using the ``other commodity'' conversion factors.
[Bank]s must use an OTC derivative contract's effective notional
principal amount (that is, its apparent or stated notional principal
amount multiplied by any multiplier in the OTC derivative contract)
rather than its apparent or stated notional principal amount in
calculating potential future credit exposure. PFE of the protection
provider of a credit derivative is capped at the net present value of
the amount of unpaid premiums.
Table 4.--Conversion Factor Matrix for OTC Derivative Contracts*
--------------------------------------------------------------------------------------------------------------------------------------------------------
Credit Credit (non-
Foreign (investment investment Precious
Remaining maturity** Interest exchange grade grade Equity metals Other
rate rate and reference reference (except commodity
gold obligor)*** obligor) gold)
--------------------------------------------------------------------------------------------------------------------------------------------------------
One year or less........................................... 0.00 0.01 0.05 0.10 0.06 0.07 0.10
Over one to five years..................................... 0.005 0.05 0.05 0.10 0.08 0.07 0.12
Over five years............................................ 0.015 0.075 0.05 0.10 0.10 0.08 0.15
--------------------------------------------------------------------------------------------------------------------------------------------------------
* For an OTC derivative contract with multiple exchanges of principal, the conversion factor is multiplied by the number of remaining payments in the
derivative contract.
[[Page 55931]]
** For an OTC derivative contract that is structured such that on specified dates any outstanding exposure is settled and the terms are reset so that
the market value of the contract is zero, the remaining maturity equals the time until the next reset date. For an interest rate derivative contract
with a remaining maturity of greater than one year that meets these criteria, the minimum conversion factor is 0.005.
*** A [bank] must use column 4 of this table--``Credit (investment grade reference obligor)''--for a credit derivative whose reference obligor has an
outstanding unsecured long-term debt security without credit enhancement that has a long-term applicable external rating of at least investment grade.
A [bank] must use column 5 of the table for all other credit derivatives.
(6) Multiple OTC derivative contracts subject to a qualifying
master netting agreement. Except as modified by paragraph (b)(7) of
this section, the EAD for multiple OTC derivative contracts subject to
a qualifying master netting agreement is equal to the sum of the net
current credit exposure and the adjusted sum of the PFE exposure for
all OTC derivative contracts subject to the qualifying master netting
agreement.
(i) Net current credit exposure. The net current credit exposure is
the greater of:
(A) The net sum of all positive and negative mark-to-market values
of the individual OTC derivative contracts subject to the qualifying
master netting agreement; or
(B) zero.
(ii) Adjusted sum of the PFE. The adjusted sum of the PFE is
calculated as Anet = (0.4 x Agross) + (0.6 x NGR x Agross), where:
(A) Anet = the adjusted sum of the PFE;
(B) Agross = the gross PFE (that is, the sum of the PFE amounts (as
determined under paragraph (b)(5)(ii) of this section) for each
individual OTC derivative contract subject to the qualifying master
netting agreement); and
(C) NGR = the net to gross ratio (that is, the ratio of the net
current credit exposure to the gross current credit exposure). In
calculating the NGR, the gross current credit exposure equals the sum
of the positive current credit exposures (as determined under paragraph
(b)(5)(i) of this section) of all individual OTC derivative contracts
subject to the qualifying master netting agreement.
(7) Collateralized OTC derivative contracts. A [bank] may recognize
the credit risk mitigation benefits of financial collateral that
secures an OTC derivative contract or single-product set of OTC
derivatives subject to a qualifying master netting agreement (netting
set) by factoring the collateral into its ELGD and LGD estimates for
the contract or netting set. Alternatively, a [bank] may recognize the
credit risk mitigation benefits of financial collateral that secures
such a contract or netting set that is marked to market on a daily
basis and subject to a daily margin maintenance requirement by
estimating an unsecured ELGD and LGD for the contract or netting set
and adjusting the EAD calculated under paragraph (b)(5) or (b)(6) of
this section using the collateral haircut approach in paragraph (a)(2)
of this section. The [bank] must substitute the EAD calculated under
paragraph (b)(5) or (b)(6) of this section for [Sigma]E in the equation
in paragraph (a)(2)(i) of this section and must use a 10-business-day
minimum holding period (TM = 10).
(c) Internal models methodology. (1) With prior written approval
from [AGENCY], a [bank] may use the internal models methodology in this
paragraph (c) to determine EAD for counterparty credit risk for OTC
derivative contracts (collateralized or uncollateralized) and single-
product netting sets thereof, for eligible margin loans and single-
product netting sets thereof, and for repo-style transactions and
single-product netting sets thereof. A [bank] that uses the internal
models methodology for a particular transaction type (OTC derivative
contracts, eligible margin loans, or repo-style transactions) must use
the internal models methodology for all transactions of that
transaction type. A [bank] may choose to use the internal models
methodology for one or two of these three types of exposures and not
the other types. A [bank] may also use the internal models methodology
for OTC derivative contracts, eligible margin loans, and repo-style
transactions subject to a qualifying cross-product netting agreement
if:
(i) The [bank] effectively integrates the risk mitigating effects
of cross-product netting into its risk management and other information
technology systems; and
(ii) The [bank] obtains the prior written approval of the [AGENCY].
A [bank] that uses the internal models methodology for a type of
exposures must receive approval from the [AGENCY] to cease using the
methodology for that type of exposures or to make a material change to
its internal model.
(2) Under the internal models methodology, a [bank] uses an
internal model to estimate the expected exposure (EE) for a netting set
and then calculates EAD based on that EE.
(i) The [bank] must use its internal model's probability
distribution for changes in the market value of an exposure or netting
set that are attributable to changes in market variables to determine
EE. The [bank] may include financial collateral currently posted by the
counterparty as collateral when calculating EE.
(ii) Under the internal models methodology, EAD = [alpha] x
effective EPE, or, subject to [AGENCY] approval as provided in
paragraph (c)(7), a more conservative measure of EAD.
[GRAPHIC] [TIFF OMITTED] TP25SE06.081
(that is, effective EPE is the time-weighted average of effective EE
where the weights are the proportion that an individual effective EE
represents in a one year time interval) where:
(1) Effective EEtk = max
(EffectiveEEtk-1,EEtk (that is, for a specific
date tk, effective EE is the greater of EE at that date or
the effective EE at the previous date); and
(2) tk represents the kth future time period
in the model and there are n time periods represented in the model over
the first year; and
(B) [alpha] = 1.4 except as provided in paragraph (c)(6), or when
[AGENCY] has determined that the [bank] must set [alpha] higher based
on the [bank]'s specific characteristics of counterparty credit risk.
(3) To obtain [AGENCY] approval to calculate the distributions of
exposures upon which the EAD calculation is based, the [bank] must
demonstrate to the satisfaction of [AGENCY] that it has been using for
at least one year an internal model that broadly meets the following
minimum standards, with which the [bank] must maintain compliance:
[[Page 55932]]
(i) The model must have the systems capability to estimate the
expected exposure to the counterparty on a daily basis (but is not
expected to estimate or report expected exposure on a daily basis).
(ii) The model must estimate expected exposure at enough future
dates to accurately reflect all the future cash flows of contracts in
the netting set.
(iii) The model must account for the possible non-normality of the
exposure distribution, where appropriate.
(iv) The [bank] must measure, monitor, and control current
counterparty exposure and the exposure to the counterparty over the
whole life of all contracts in the netting set.
(v) The [bank] must measure and manage current exposures gross and
net of collateral held, where appropriate. The [bank] must estimate
expected exposures for OTC derivative contracts both with and without
the effect of collateral agreements.
(vi) The [bank] must have procedures to identify, monitor, and
control specific wrong-way risk throughout the life of an exposure.
Wrong-way risk in this context is the risk that future exposure to a
counterparty will be high when the counterparty's probability of
default is also high.
(vii) The model must use current market data to compute current
exposures. When estimating model parameters based on historical data,
at least three years of historical data that cover a wide range of
economic conditions must be used and must be updated quarterly or more
frequently if market conditions warrant. The [bank] should consider
using model parameters based on forward-looking measures such as
implied volatilities, where appropriate.
(viii) A [bank] must subject its internal model to an initial
validation and annual model review process. The model review should
consider whether the inputs and risk factors, as well as the model
outputs, are appropriate.
(4) Maturity. (i) If the remaining maturity of the exposure or the
longest-dated contract in the netting set is greater than one year, the
[bank] must set M for the exposure or netting set equal to the lower of
5 years or M(EPE), where:
[GRAPHIC] [TIFF OMITTED] TP25SE06.059
(B) dfk is the risk-free discount factor for future time
period tk; and
(C) [Delta]tk = tk - tk-1.
(ii) If the remaining maturity of the exposure or the longest-dated
contract in the netting set is one year or less, the [bank] must set M
for the exposure or netting set equal to 1 year, except as provided in
paragraph (d)(7) of section 31.
(5) Collateral agreements. A [bank] may capture the effect on EAD
of a collateral agreement that requires receipt of collateral when
exposure to the counterparty increases but may not capture the effect
on EAD of a collateral agreement that requires receipt of collateral
when counterparty credit quality deteriorates. For this purpose, a
collateral agreement means a legal contract that specifies the time
when, and circumstances under which, the counterparty is required to
exchange collateral with the [bank] for a single financial contract or
for all financial contracts covered under a qualifying master netting
agreement and confers upon the [bank] a perfected, first priority
security interest, or the legal equivalent thereof, in the collateral
posted by the counterparty under the agreement. This security interest
must provide the [bank] with a right to close out the financial
positions and the collateral upon an event of default of, or failure to
perform by, the counterparty under the collateral agreement. A contract
would not satisfy this requirement if the [bank]'s exercise of rights
under the agreement may be stayed or avoided under applicable law in
the relevant jurisdictions. Two methods are available to capture the
effect of a collateral agreement:
(i) With prior written approval from [AGENCY], a [bank] may include
the effect of a collateral agreement within its internal model used to
calculate EAD. The [bank] may set EAD equal to the expected exposure at
the end of the margin period of risk. The margin period of risk means,
with respect to a netting set subject to a collateral agreement, the
time period from the most recent exchange of collateral with a
counterparty until the next required exchange of collateral plus the
period of time required to sell and realize the proceeds of the least
liquid collateral that can be delivered under the terms of the
collateral agreement, and, where applicable, the period of time
required to re-hedge the resulting market risk, upon the default of the
counterparty. The minimum margin period of risk is 5 business days for
repo-style transactions and 10 business days for other transactions
when liquid financial collateral is posted under a daily margin
maintenance requirement. This period should be extended to cover any
additional time between margin calls; any potential closeout
difficulties; any delays in selling collateral, particularly if the
collateral is illiquid; and any impediments to prompt re-hedging of any
market risk.
(ii) A [bank] that can model EPE without collateral agreements but
cannot achieve the higher level of modeling sophistication to model EPE
with collateral agreements can set effective EPE for a collateralized
counterparty equal to the lesser of:
(A) The threshold, defined as the exposure amount at which the
counterparty is required to post collateral under the collateral
agreement, if the threshold is positive, plus an add-on that reflects
the potential increase in exposure over the margin period of risk. The
add-on is computed as the expected increase in the netting set's
exposure beginning from current exposure of zero over the margin period
of risk. The margin period of risk must be at least five business days
for exposures or netting sets consisting only of repo-style
transactions subject to daily re-margining and daily marking-to-market,
and 10 business days for all other exposures or netting sets; or
(B) Effective EPE without a collateral agreement.
(6) Own estimate of alpha. With prior written approval of [AGENCY],
a [bank] may calculate alpha as the ratio of economic capital from a
full simulation of counterparty exposure across counterparties that
incorporates a joint simulation of market and credit risk factors
(numerator) and economic capital based on EPE (denominator), subject to
a floor of 1.2. For purposes of this calculation, economic capital is
the unexpected losses for all counterparty
[[Page 55933]]
credit risks measured at a 99.9 percent confidence level over a one-
year horizon. To receive approval, the [bank] must meet the following
minimum standards to the satisfaction of [AGENCY]:
(i) The [bank]'s own estimate of alpha must capture in the
numerator the effects of:
(A) The material sources of stochastic dependency of distributions
of market values of transactions or portfolios of transactions across
counterparties;
(B) Volatilities and correlations of market risk factors used in
the joint simulation, which must be related to the credit risk factor
used in the simulation to reflect potential increases in volatility or
correlation in an economic downturn, where appropriate; and
(C) The granularity of exposures, that is, the effect of a
concentration in the proportion of each counterparty's exposure that is
driven by a particular risk factor.
(ii) The [bank] must assess the potential model risk in its
estimates of alpha.
(iii) The [bank] must calculate the numerator and denominator of
alpha in a consistent fashion with respect to modeling methodology,
parameter specifications, and portfolio composition.
(iv) The [bank] must review and adjust as appropriate its estimates
of the numerator and denominator on at least a quarterly basis and more
frequently when the composition of the portfolio varies over time.
(7) Other measures of counterparty exposure. With prior written
approval of [AGENCY], a [bank] may set EAD equal to a measure of
counterparty credit risk exposure, such as peak EAD, that is more
conservative than an alpha of 1.4 (or higher under the terms of
paragraph (c)(2)(ii)(B)) times EPE for every counterparty whose EAD
will be measured under the alternative measure of counterparty
exposure. The [bank] must demonstrate the conservatism of the measure
of counterparty credit risk exposure used for EAD.
Section 33. Guarantees and Credit Derivatives: PD Substitution and LGD
Adjustment Treatments
(a) Scope. (1) This section applies to wholesale exposures for
which:
(i) Credit risk is fully covered by an eligible guarantee or
eligible credit derivative; and
(ii) Credit risk is covered on a pro rata basis (that is, on a
basis in which the [bank] and the protection provider share losses
proportionately) by an eligible guarantee or eligible credit
derivative.
(2) Wholesale exposures on which there is a tranching of credit
risk (reflecting at least two different levels of seniority) are
securitization exposures subject to the securitization framework in
part V.
(3) A [bank] may elect to recognize the credit risk mitigation
benefits of an eligible guarantee or eligible credit derivative
covering an exposure described in paragraph (a)(1) of this section by
using the PD substitution approach or the LGD adjustment approach in
paragraph (c) of this section or using the double default treatment in
section 34 (if the transaction qualifies for the double default
treatment in section 34). A [bank]'s PD and LGD for the hedged exposure
may not be lower than the PD and LGD floors described in paragraphs
(d)(2) and (d)(3) of section 31.
(4) A [bank] must use the same risk parameters for calculating ECL
as it uses for calculating the risk-based capital requirement for the
exposure.
(b) Rules of recognition. (1) A [bank] may only recognize the
credit risk mitigation benefits of eligible guarantees and eligible
credit derivatives.
(2) A [bank] may only recognize the credit risk mitigation benefits
of an eligible credit derivative to hedge an exposure that is different
from the credit derivative's reference exposure used for determining
the derivative's cash settlement value, deliverable obligation, or
occurrence of a credit event if:
(i) The reference exposure ranks pari passu (that is, equally) with
or is junior to the hedged exposure; and
(ii) The reference exposure and the hedged exposure share the same
obligor (that is, the same legal entity), and legally enforceable
cross-default or cross-acceleration clauses are in place.
(c) Risk parameters for hedged exposures--(1) PD substitution
approach--(i) Full coverage. If an eligible guarantee or eligible
credit derivative meets the conditions in paragraphs (a) and (b) of
this section and the protection amount (P) of the guarantee or credit
derivative is greater than or equal to the EAD of the hedged exposure,
a [bank] may recognize the guarantee or credit derivative in
determining the [bank]'s risk-based capital requirement for the hedged
exposure by substituting the PD associated with the rating grade of the
protection provider for the PD associated with the rating grade of the
obligor in the risk-based capital formula in Table 2 and using the
appropriate ELGD and LGD as described in paragraphs (c)(1)(iii) and
(iv) of this section. If the [bank] determines that full substitution
of the protection provider's PD leads to an inappropriate degree of
risk mitigation, the [bank] may substitute a higher PD than that of the
protection provider.
(ii) Partial coverage. If an eligible guarantee or eligible credit
derivative meets the conditions in paragraphs (a) and (b) of this
section and the protection amount (P) of the guarantee or credit
derivative is less than the EAD of the hedged exposure, the [bank] must
treat the hedged exposure as two separate exposures (protected and
unprotected) in order to recognize the credit risk mitigation benefit
of the guarantee or credit derivative.
(A) The [bank] must calculate its risk-based capital requirement
for the protected exposure under section 31, where PD is the protection
provider's PD, ELGD and LGD are determined under paragraphs (c)(1)(iii)
and (iv) of this section, and EAD is P. If the [bank] determines that
full substitution leads to an inappropriate degree of risk mitigation,
the [bank] may use a higher PD than that of the protection provider.
(B) The [bank] must calculate its risk-based capital requirement
for the unprotected exposure under section 31, where PD is the
obligor's PD, ELGD is the hedged exposure's ELGD (not adjusted to
reflect the guarantee or credit derivative), LGD is the hedged
exposure's LGD (not adjusted to reflect the guarantee or credit
derivative), and EAD is the EAD of the original hedged exposure minus
P.
(C) The treatment in this paragraph (c)(1)(ii) is applicable when
the credit risk of a wholesale exposure is covered on a pro rata basis
or when an adjustment is made to the effective notional amount of the
guarantee or credit derivative under paragraphs (d), (e), or (f) of
this section.
(iii) LGD of hedged exposures. The LGD of a hedged exposure under
the PD substitution approach is equal to:
(A) The lower of the LGD of the hedged exposure (not adjusted to
reflect the guarantee or credit derivative) and the LGD of the
guarantee or credit derivative, if the guarantee or credit derivative
provides the [bank] with the option to receive immediate payout upon
triggering the protection; or
(B) The LGD of the guarantee or credit derivative, if the guarantee
or credit derivative does not provide the [bank] with the option to
receive immediate payout upon triggering the protection.
(iv) ELGD of hedged exposures. The ELGD of a hedged exposure under
the PD substitution approach is equal to the ELGD associated with the
LGD determined under paragraph (c)(1)(iii) of this section.
[[Page 55934]]
(2) LGD adjustment approach--(i) Full coverage. If an eligible
guarantee or eligible credit derivative meets the conditions in
paragraphs (a) and (b) of this section and the protection amount (P) of
the guarantee or credit derivative is greater than or equal to the EAD
of the hedged exposure, the [bank]'s risk-based capital requirement for
the hedged exposure would be the greater of:
(A) The risk-based capital requirement for the exposure as
calculated under section 31, with the ELGD and LGD of the exposure
adjusted to reflect the guarantee or credit derivative; or
(B) The risk-based capital requirement for a direct exposure to the
protection provider as calculated under section 31, using the PD for
the protection provider, the ELGD and LGD for the guarantee or credit
derivative, and an EAD equal to the EAD of the hedged exposure.
(ii) Partial coverage. If an eligible guarantee or eligible credit
derivative meets the conditions in paragraphs (a) and (b) of this
section and the protection amount (P) of the guarantee or credit
derivative is less than the EAD of the hedged exposure, the [bank] must
treat the hedged exposure as two separate exposures (protected and
unprotected) in order to recognize the credit risk mitigation benefit
of the guarantee or credit derivative.
(A) The [bank]'s risk-based capital requirement for the protected
exposure would be the greater of:
(1) The risk-based capital requirement for the protected exposure
as calculated under section 31, with the ELGD and LGD of the exposure
adjusted to reflect the guarantee or credit derivative and EAD set
equal to P; or
(2) The risk-based capital requirement for a direct exposure to the
guarantor as calculated under section 31, using the PD for the
protection provider, the ELGD and LGD for the guarantee or credit
derivative, and an EAD set equal to P.
(B) The [bank] must calculate its risk-based capital requirement
for the unprotected exposure under section 31, where PD is the
obligor's PD, ELGD is the hedged exposure's ELGD (not adjusted to
reflect the guarantee or credit derivative), LGD is the hedged
exposure's LGD (not adjusted to reflect the guarantee or credit
derivative), and EAD is the EAD of the original hedged exposure minus
P.
(3) M of hedged exposures. The M of the hedged exposure is the same
as the M of the exposure if it were unhedged.
(d) Maturity mismatch. (1) A [bank] that recognizes an eligible
guarantee or eligible credit derivative in determining its risk-based
capital requirement for a hedged exposure must adjust the protection
amount of the credit risk mitigant to reflect any maturity mismatch
between the hedged exposure and the credit risk mitigant.
(2) A maturity mismatch occurs when the residual maturity of a
credit risk mitigant is less than that of the hedged exposure(s). When
a credit risk mitigant covers multiple hedged exposures that have
different residual maturities, the longest residual maturity of any of
the hedged exposures must be taken as the residual maturity of the
hedged exposures.
(3) The residual maturity of a hedged exposure is the longest
possible remaining time before the obligor is scheduled to fulfill its
obligation on the exposure. If a credit risk mitigant has embedded
options that may reduce its term, the [bank] (protection purchaser)
must use the shortest possible residual maturity for the credit risk
mitigant. If a call is at the discretion of the protection provider,
the residual maturity of the credit risk mitigant is at the first call
date. If the call is at the discretion of the [bank] (protection
purchaser), but the terms of the arrangement at origination of the
credit risk mitigant contain a positive incentive for the [bank] to
call the transaction before contractual maturity, the remaining time to
the first call date is the residual maturity of the credit risk
mitigant. For example, where there is a step-up in cost in conjunction
with a call feature or where the effective cost of protection increases
over time even if credit quality remains the same or improves, the
residual maturity of the credit risk mitigant will be the remaining
time to the first call.
(4) A credit risk mitigant with a maturity mismatch may be
recognized only if its original maturity is greater than or equal to
one year and its residual maturity is greater than three months.
(5) When a maturity mismatch exists, the [bank] must apply the
following adjustment to reduce the protection amount of the credit risk
mitigant: Pm = E x (t-0.25)/(T-0.25), where:
(i) Pm = protection amount of the credit risk mitigant, adjusted
for maturity mismatch;
(ii) E = effective notional amount of the credit risk mitigant;
(iii) t = the lesser of T or the residual maturity of the credit
risk mitigant, expressed in years; and
(iv) T = the lesser of 5 or the residual maturity of the hedged
exposure, expressed in years.
(e) Credit derivatives without restructuring as a credit event. If
a [bank] recognizes an eligible credit derivative that does not include
as a credit event a restructuring of the hedged exposure involving
forgiveness or postponement of principal, interest, or fees that
results in a credit loss event (that is, a charge-off, specific
provision, or other similar debit to the profit and loss account), the
[bank] must apply the following adjustment to reduce the protection
amount of the credit derivative: Pr = Pm x 0.60, where:
(1) Pr = protection amount of the credit derivative, adjusted for
lack of restructuring event (and maturity mismatch, if applicable); and
(2) Pm = effective notional amount of the credit derivative
(adjusted for maturity mismatch, if applicable).
(f) Currency mismatch. (1) If a [bank] recognizes an eligible
guarantee or eligible credit derivative that is denominated in a
currency different from that in which the hedged exposure is
denominated, the protection amount of the guarantee or credit
derivative is reduced by application of the following formula: Pc = Pr
x (1 x HFX), where:
(i) Pc = protection amount of the guarantee or credit derivative,
adjusted for currency mismatch (and maturity mismatch and lack of
restructuring event, if applicable);
(ii) Pr = effective notional amount of the guarantee or credit
derivative (adjusted for maturity mismatch and lack of restructuring
event, if applicable); and
(iii) HFX = haircut appropriate for the currency
mismatch between the guarantee or credit derivative and the hedged
exposure.
(2) A [bank] must set HFX equal to 8 percent unless it
qualifies for the use of and uses its own internal estimates of foreign
exchange volatility based on a 10-business day holding period and daily
marking-to-market and remargining. A [bank] qualifies for the use of
its own internal estimates of foreign exchange volatility if it
qualifies for:
(i) The own-estimates haircuts in paragraph (a)(2)(iii) of section
32;
(ii) The simple VaR methodology in paragraph (a)(3) of section 32;
or
(iii) The internal models methodology in paragraph (c) of section
32.
(3) A [bank] must adjust HFX calculated in paragraph
(f)(2) of this section upward if the [bank] revalues the guarantee or
credit derivative less frequently than once every 10 business days
using the square root of time formula provided in paragraph
(a)(2)(iii)(A)(2) of section 32.
[[Page 55935]]
Section 34. Guarantees and Credit Derivatives: Double Default Treatment
(a) Eligibility and operational criteria for double default
treatment. A [bank] may recognize the credit risk mitigation benefits
of a guarantee or credit derivative covering an exposure described in
paragraph (a)(1) of section 33 by applying the double default treatment
in this section if all the following criteria are satisfied.
(1) The hedged exposure is fully covered or covered on a pro rata
basis by:
(i) An eligible guarantee issued by an eligible double default
guarantor; or
(ii) An eligible credit derivative that meets the requirements of
paragraph (b)(2) of section 33 and is issued by an eligible double
default guarantor.
(2) The guarantee or credit derivative is:
(i) An uncollateralized guarantee or uncollateralized credit
derivative (for example, a credit default swap) that provides
protection with respect to a single reference obligor; or
(ii) An nth-to-default credit derivative (subject to the
requirements of paragraph (m) of section 42).
(3) The hedged exposure is a wholesale exposure (other than a
sovereign exposure).
(4) The obligor of the hedged exposure is not:
(i) An eligible double default guarantor or an affiliate of an
eligible double default guarantor; or
(ii) An affiliate of the guarantor.
(5) The [bank] does not recognize any credit risk mitigation
benefits of the guarantee or credit derivative for the hedged exposure
other than through application of the double default treatment as
provided in this section.
(6) The [bank] has implemented a process (which has received the
prior, written approval of the [AGENCY]) to detect excessive
correlation between the creditworthiness of the obligor of the hedged
exposure and the protection provider. If excessive correlation is
present, the [bank] may not use the double default treatment for the
hedged exposure.
(b) Full coverage. If the transaction meets the criteria in
paragraph (a) of this section and the protection amount (P) of the
guarantee or credit derivative is at least equal to the EAD of the
hedged exposure, the [bank] may determine its risk-weighted asset
amount for the hedged exposure under paragraph (e) of this section.
(c) Partial coverage. If the transaction meets the criteria in
paragraph (a) of this section and the protection amount (P) of the
guarantee or credit derivative is less than the EAD of the hedged
exposure, the [bank] must treat the hedged exposure as two separate
exposures (protected and unprotected) in order to recognize double
default treatment on the protected portion of the exposure.
(1) For the protected exposure, the [bank] must set EAD equal to P
and calculate its risk-weighted asset amount as provided in paragraph
(e) of this section.
(2) For the unprotected exposure, the [bank] must set EAD equal to
the EAD of the original exposure minus P and then calculate its risk-
weighted asset amount as provided in section 31.
(d) Mismatches. For any hedged exposure to which a [bank] applies
double default treatment, the [bank] must make applicable adjustments
to the protection amount as required in paragraphs (d), (e), and (f) of
section 33.
(e) The double default dollar risk-based capital requirement. The
dollar risk-based capital requirement for a hedged exposure to which a
[bank] has applied double default treatment is KDD
multiplied by the EAD of the exposure. KDD is calculated
according to the following formula: KDD = Ko x
(0.15 + 160 x PDg), where:
[GRAPHIC] [TIFF OMITTED] TP25SE06.060
(2) PDg = PD of the protection provider.
(3) PDo = PD of the obligor of the hedged exposure.
(4) LGDg = (i) The lower of the LGD of the unhedged
exposure and the LGD of the guarantee or credit derivative, if the
guarantee or credit derivative provides the [bank] with the option to
receive immediate payout on triggering the protection; or
(ii) The LGD of the guarantee or credit derivative, if the
guarantee or credit derivative does not provide the [bank] with the
option to receive immediate payout on triggering the protection.
(5) ELGDg = The ELGD associated with LGDg.
(6) [rho]os (asset value correlation of the obligor) is
calculated according to the appropriate formula for (R) provided in
Table 2 in section 31, with PD equal to PDo.
(7) b (maturity adjustment coefficient) is calculated according to
the formula for b provided in Table 2 in section 31, with PD equal to
the lesser of PDo and PDg.
(8) M (maturity) is the effective maturity of the guarantee or
credit derivative, which may not be less than one year or greater than
five years.
Section 35. Risk-Based Capital Requirement for Unsettled Transactions
(a) Definitions. For purposes of this section:
(1) Delivery-versus-payment (DvP) transaction means a securities or
commodities transaction in which the buyer is obligated to make payment
only if the seller has made delivery of the securities or commodities
and the seller is obligated to deliver the securities or commodities
only if the buyer has made payment.
(2) Payment-versus-payment (PvP) transaction means a foreign
exchange transaction in which each counterparty is obligated to make a
final transfer of one or more currencies only if the other counterparty
has made a final transfer of one or more currencies.
(3) Normal settlement period. A transaction has a normal settlement
period if the contractual settlement period for the transaction is
equal to or less than the market standard for the instrument underlying
the transaction and equal to or less than 5 business days.
(4) Positive current exposure. The positive current exposure of a
[bank] for a transaction is the difference between the transaction
value at the agreed settlement price and the current market price of
the transaction, if the difference results in a credit exposure of the
[bank] to the counterparty.
(b) Scope. This section applies to all transactions involving
securities, foreign exchange instruments, and commodities that have a
risk of delayed settlement or delivery. This section does not apply to:
(1) Transactions accepted by a qualifying central counterparty that
are subject to daily marking-to-market and daily receipt and payment of
variation margin;
[[Page 55936]]
(2) Repo-style transactions (which are addressed in sections 31 and
32); \9\
---------------------------------------------------------------------------
\9\ Unsettled repo-style transactions are treated as repo-style
transactions under sections 31 and 32.
---------------------------------------------------------------------------
(3) One-way cash payments on OTC derivative contracts (which are
addressed in sections 31 and 32); or
(4) Transactions with a contractual settlement period that is
longer than the normal settlement period (which are treated as OTC
derivative contracts and addressed in sections 31 and 32).
(c) System-wide failures. In the case of a system-wide failure of a
settlement or clearing system, the [AGENCY] may waive risk-based
capital requirements for unsettled and failed transactions until the
situation is rectified.
(d) Delivery-versus-payment (DvP) and payment-versus-payment (PvP)
transactions. A [bank] must hold risk-based capital against any DvP or
PvP transaction with a normal settlement period if the [bank]'s
counterparty has not made delivery or payment within five business days
after the settlement date. The [bank] must determine its risk-weighted
asset amount for such a transaction by multiplying the positive current
exposure of the transaction for the [bank] by the appropriate risk
weight in Table 5.
Table 5.--Risk Weights for Unsettled DvP and PvP Transactions
------------------------------------------------------------------------
Risk weight to
be applied to
Number of business days after contractual settlement positive
date current
exposure
(percent)
------------------------------------------------------------------------
From 5 to 15............................................ 100
From 16 to 30........................................... 625
From 31 to 45........................................... 937.5
46 or more.............................................. 1,250
------------------------------------------------------------------------
(e) Non-DvP/non-PvP (non-delivery-versus-payment/non-payment-
versus-payment) transactions. (1) A [bank] must hold risk-based capital
against any non-DvP/non-PvP transaction with a normal settlement period
if the [bank] has delivered cash, securities, commodities, or
currencies to its counterparty but has not received its corresponding
deliverables by the end of the same business day. The [bank] must
continue to hold risk-based capital against the transaction until the
[bank] has received its corresponding deliverables.
(2) From the business day after the [bank] has made its delivery
until five business days after the counterparty delivery is due, the
[bank] must calculate its risk-based capital requirement for the
transaction by treating the current market value of the deliverables
owed to the [bank] as a wholesale exposure.
(i) A [bank] may assign an obligor rating to a counterparty for
which it is not otherwise required under this rule to assign an obligor
rating on the basis of the applicable external rating of any
outstanding unsecured long-term debt security without credit
enhancement issued by the counterparty.
(ii) A [bank] may use a 45 percent ELGD and LGD for the transaction
rather than estimating ELGD and LGD for the transaction provided the
[bank] uses the 45 percent ELGD and LGD for all transactions described
in paragraphs (e)(1) and (e)(2) of this section.
(iii) A [bank] may use a 100 percent risk weight for the
transaction provided the [bank] uses this risk weight for all
transactions described in paragraphs (e)(1) and (e)(2) of this section.
(3) If the [bank] has not received its deliverables by the fifth
business day after counterparty delivery was due, the [bank] must
deduct the current market value of the deliverables owed to the [bank]
50 percent from tier 1 capital and 50 percent from tier 2 capital.
(f) Total risk-weighted assets for unsettled transactions. Total
risk-weighted assets for unsettled transactions is the sum of the risk-
weighted asset amounts of all DvP, PvP, and non-DvP/non-PvP
transactions.
Part V. Risk-Weighted Assets for Securitization Exposures
Section 41. Operational Criteria for Recognizing the Transfer of Risk
(a) Operational criteria for traditional securitizations. A [bank]
that transfers exposures it has originated or purchased to an SPE or
other third party in connection with a traditional securitization may
exclude the exposures from the calculation of its risk-weighted assets
only if each of the conditions in this paragraph (a) is satisfied. A
[bank] that meets these conditions must hold risk-based capital against
any securitization exposures it retains in connection with the
securitization. A [bank] that fails to meet these conditions must hold
risk-based capital against the transferred exposures as if they had not
been securitized and must deduct from tier 1 capital any after-tax
gain-on-sale resulting from the transaction. The conditions are:
(1) The transfer is considered a sale under GAAP;
(2) The [bank] has transferred to third parties credit risk
associated with the underlying exposures; and
(3) Any clean-up calls relating to the securitization are eligible
clean-up calls.
(b) Operational criteria for synthetic securitizations. For
synthetic securitizations, a [bank] may recognize for risk-based
capital purposes the use of a credit risk mitigant to hedge underlying
exposures only if each of the conditions in this paragraph (b) is
satisfied. A [bank] that fails to meet these conditions must hold risk-
based capital against the underlying exposures as if they had not been
synthetically securitized. The conditions are:
(1) The credit risk mitigant is financial collateral, an eligible
credit derivative from an eligible securitization guarantor, or an
eligible guarantee from an eligible securitization guarantor;
(2) The [bank] transfers credit risk associated with the underlying
exposures to third parties, and the terms and conditions in the credit
risk mitigants employed do not include provisions that:
(i) Allow for the termination of the credit protection due to
deterioration in the credit quality of the underlying exposures;
(ii) Require the [bank] to alter or replace the underlying
exposures to improve the credit quality of the pool of underlying
exposures;
(iii) Increase the [bank]'s cost of credit protection in response
to deterioration in the credit quality of the underlying exposures;
(iv) Increase the yield payable to parties other than the [bank] in
response to a deterioration in the credit quality of the underlying
exposures; or
(v) Provide for increases in a retained first loss position or
credit enhancement provided by the [bank] after the inception of the
securitization;
(3) The [bank] obtains a well-reasoned opinion from legal counsel
that confirms the enforceability of the credit risk mitigant in all
relevant jurisdictions; and
(4) Any clean-up calls relating to the securitization are eligible
clean-up calls.
Section 42. Risk-Based Capital Requirement for Securitization Exposures
(a) Hierarchy of approaches. Except as provided elsewhere in this
section:
(1) A [bank] must deduct from tier 1 capital any after-tax gain-on-
sale resulting from a securitization and must deduct from total capital
in accordance with paragraph (c) of this section the portion of any
CEIO that does not constitute gain-on-sale.
(2) If a securitization exposure does not require deduction under
paragraph (a)(1) of this section and qualifies for the Ratings-Based
Approach in section 43, a [bank] must apply the Ratings-Based Approach
to the exposure.
[[Page 55937]]
(3) If a securitization exposure does not require deduction under
paragraph (a)(1) of this section and does not qualify for the Ratings-
Based Approach, the [bank] may either apply the Internal Assessment
Approach in section 44 to the exposure (if the [bank] and the relevant
ABCP program qualify for the Internal Assessment Approach) or the
Supervisory Formula Approach in section 45 to the exposure (if the
[bank] and the exposure qualify for the Supervisory Formula Approach).
(4) If a securitization exposure does not require deduction under
paragraph (a)(1) of this section and does not qualify for the Ratings-
Based Approach, the Internal Assessment Approach, or the Supervisory
Formula Approach, the [bank] must deduct the exposure from total
capital in accordance with paragraph (c) of this section.
(b) Total risk-weighted assets for securitization exposures. A
[bank]'s total risk-weighted assets for securitization exposures is
equal to the sum of its risk-weighted assets calculated using the
Ratings-Based Approach in section 43, the Internal Assessment Approach
in section 44, and the Supervisory Formula Approach in section 45, and
its risk-weighted assets amount for early amortization provisions
calculated in section 47.
(c) Deductions. (1) If a [bank] must deduct a securitization
exposure from total capital, the [bank] must take the deduction 50
percent from tier 1 capital and 50 percent from tier 2 capital. If the
amount deductible from tier 2 capital exceeds the [bank]'s tier 2
capital, the [bank] must deduct the excess from tier 1 capital.
(2) A [bank] may calculate any deduction from regulatory capital
for a securitization exposure net of any deferred tax liabilities
associated with the securitization exposure.
(d) Maximum risk-based capital requirement. Regardless of any other
provisions of this part, unless one or more underlying exposures does
not meet the definition of a wholesale, retail, securitization, or
equity exposure, the total risk-based capital requirement for all
securitization exposures held by a single [bank] associated with a
single securitization (including any risk-based capital requirements
that relate to an early amortization provision of the securitization
but excluding any risk-based capital requirements that relate to the
[bank]'s gain-on-sale or CEIOs associated with the securitization) may
not exceed the sum of:
(1) The [bank]'s total risk-based capital requirement for the
underlying exposures as if the [bank] directly held the underlying
exposures; plus
(2) The total ECL of the underlying exposures.
(e) Amount of a securitization exposure. (1) The amount of an on-
balance sheet securitization exposure is:
(i) The [bank]'s carrying value, if the exposure is held-to-
maturity or for trading; or
(ii) The [bank]'s carrying value minus any unrealized gains and
plus any unrealized losses on the exposure, if the exposure is
available-for-sale.
(2) The amount of an off-balance sheet securitization exposure is
the notional amount of the exposure. For a commitment, such as a
liquidity facility extended to an ABCP program, the notional amount may
be reduced to the maximum potential amount that the [bank] currently
would be required to fund under the arrangement's documentation. For an
OTC derivative contract that is not a credit derivative, the notional
amount is the EAD of the derivative contract (as calculated in section
32).
(f) Overlapping exposures--(1) ABCP programs. If a [bank] has
multiple securitization exposures to an ABCP program that provide
duplicative coverage of the underlying exposures of a securitization
(such as when a [bank] provides a program-wide credit enhancement and
multiple pool-specific liquidity facilities to an ABCP program), the
[bank] is not required to hold duplicative risk-based capital against
the overlapping position. Instead, the [bank] may apply to the
overlapping position the applicable risk-based capital treatment that
results in the highest risk-based capital requirement.
(2) Mortgage loan swaps. If a [bank] holds a mortgage-backed
security or participation certificate as a result of a mortgage loan
swap with recourse, and the transaction is a securitization exposure,
the [bank] must determine a risk-weighted asset amount for the recourse
obligation plus the percentage of the mortgage-backed security or
participation certificate that is not covered by the recourse
obligation. The total risk-weighted asset amount for the transaction is
capped at the risk-weighted asset amount for the underlying exposures
as if they were held directly on the [bank]'s balance sheet.
(g) Securitizations of non-IRB exposures. Regardless of paragraph
(a) of this section, if a [bank] has a securitization exposure where
any underlying exposure is not a wholesale exposure, retail exposure,
securitization exposure, or equity exposure, the [bank] must:
(1) If the [bank] is an originating [bank], deduct from tier 1
capital any after-tax gain-on-sale resulting from the securitization
and deduct from total capital in accordance with paragraph (c) of this
section the portion of any CEIO that does not constitute gain-on-sale;
(2) If the securitization exposure does not require deduction under
paragraph (g)(1), apply the RBA in section 43 to the securitization
exposure if the exposure qualifies for the RBA; and
(3) If the securitization exposure does not require deduction under
paragraph (g)(1) and does not qualify for the RBA, deduct the exposure
from total capital in accordance with paragraph (c) of this section.
(h) Implicit support. If a [bank] provides support to a
securitization in excess of the [bank]'s contractual obligation to
provide credit support to the securitization (implicit support):
(1) The [bank] must hold regulatory capital against all of the
underlying exposures associated with the securitization as if the
exposures had not been securitized and must deduct from tier 1 capital
any after-tax gain-on-sale resulting from the securitization; and
(2) The [bank] must disclose publicly:
(i) That it has provided implicit support to the securitization;
and
(ii) The regulatory capital impact to the [bank] of providing such
implicit support.
(i) Eligible servicer cash advance facilities. Regardless of any
other provisions of this part, a [bank] is not required to hold risk-
based capital against the undrawn portion of an eligible servicer cash
advance facility.
(j) Interest-only mortgage-backed securities. Regardless of any
other provisions of this part, the risk weight for a non-credit
enhancing interest-only mortgage-backed security may not be less than
100 percent.
(k) Small-business loans and leases on personal property
transferred with recourse. (1) Regardless of any other provisions of
this appendix, a [bank] that has transferred small-business loans and
leases of personal property (small-business obligations) with recourse
must include in risk-weighted assets only the contractual amount of
retained recourse if all the following conditions are met:
(i) The transaction is a sale under GAAP.
(ii) The [bank] establishes and maintains, pursuant to GAAP, a non-
capital reserve sufficient to meet the [bank]'s reasonably estimated
liability under the recourse arrangement.
(iii) The loans and leases are to businesses that meet the criteria
for a small-business concern established by the Small Business
Administration
[[Page 55938]]
under section 3(a) of the Small Business Act.
(iv) The [bank] is well capitalized, as defined in the [AGENCY]'s
prompt corrective action regulation--12 CFR part 6 (for national
banks), 12 CFR part 208, subpart D (for state member banks or bank
holding companies), 12 CFR part 325, subpart B (for state nonmember
banks), and 12 CFR part 565 (for savings associations). For purposes of
determining whether a [bank] is well capitalized for purposes of
paragraph (k) of this section, the [bank]'s capital ratios must be
calculated without regard to the preferential capital treatment for
transfers of small-business obligations with recourse specified in
paragraph (k)(1) of this section.
(2) The total outstanding amount of recourse retained by a [bank]
on transfers of small-business obligations receiving the preferential
capital treatment specified in paragraph (k)(1) of this section cannot
exceed 15 percent of the [bank]'s total qualifying capital.
(3) If a [bank] ceases to be well capitalized or exceeds the 15
percent capital limitation, the preferential capital treatment
specified in paragraph (k)(1) of this section will continue to apply to
any transfers of small-business obligations with recourse that occurred
during the time that the [bank] was well capitalized and did not exceed
the capital limit.
(4) The risk-based capital ratios of the [bank] must be calculated
without regard to the preferential capital treatment for transfers of
small-business obligations with recourse specified in paragraph (k)(1)
of this section as provided in 12 CFR part 3, Appendix A (for national
banks), 12 CFR part 208, Appendix A (for state member banks), 12 CFR
part 225, Appendix A (for bank holding companies), 12 CFR part 325,
Appendix A (for state nonmember banks), and 12 CFR 567.6(b)(5)(v) (for
savings associations).
(l) Consolidated ABCP programs--(1) A [bank] that qualifies as a
primary beneficiary and must consolidate an ABCP program as a variable
interest entity under GAAP may exclude the consolidated ABCP program
assets from risk-weighted assets if the [bank] is the sponsor of the
ABCP program. If a [bank] excludes such consolidated ABCP program
assets from risk-weighted assets, the [bank] must hold risk-based
capital against any securitization exposures of the [bank] to the ABCP
program in accordance with this part.
(2) If a [bank] either is not permitted, or elects not, to exclude
consolidated ABCP program assets from its risk-weighted assets, the
[bank] must hold risk-based capital against the consolidated ABCP
program assets in accordance with this appendix but is not required to
hold risk-based capital against any securitization exposures of the
[bank] to the ABCP program.
(m) Nth-to-default credit derivatives--(1) First-to-default credit
derivatives--(i) Protection purchaser. A [bank] that obtains credit
protection on a group of underlying exposures through a first-to-
default credit derivative must determine its risk-based capital
requirement for the underlying exposures as if the [bank] synthetically
securitized the underlying exposure with the lowest risk-based capital
requirement (K) (as calculated under Table 2) and had obtained no
credit risk mitigant on the other underlying exposures.
(ii) Protection provider. A [bank] that provides credit protection
on a group of underlying exposures through a first-to-default credit
derivative must determine its risk-weighted asset amount for the
derivative by applying the RBA in section 43 (if the derivative
qualifies for the RBA) or, if the derivative does not qualify for the
RBA, by setting its risk-weighted asset amount for the derivative equal
to the product of:
(A) The protection amount of the derivative;
(B) 12.5; and
(C) The sum of the risk-based capital requirements (K) of the
individual underlying exposures (as calculated under Table 2), up to a
maximum of 100 percent.
(2) Second-or-subsequent-to-default credit derivatives--(i)
Protection purchaser. (A) A [bank] that obtains credit protection on a
group of underlying exposures through a nth-to-default credit
derivative (other than a first-to-default credit derivative) may
recognize the credit risk mitigation benefits of the derivative only
if:
(1) The [bank] also has obtained credit protection on the same
underlying exposures in the form of first-through-(n-1)-to-default
credit derivatives; or
(2) If n-1 of the underlying exposures have already defaulted.
(B) If a [bank] satisfies the requirements of paragraph
(m)(2)(i)(A) of this section, the [bank] must determine its risk-based
capital requirement for the underlying exposures as if the [bank] had
only synthetically securitized the underlying exposure with the nth
lowest risk-based capital requirement (K) (as calculated under Table 2)
and had obtained no credit risk mitigant on the other underlying
exposures.
(ii) Protection provider. A [bank] that provides credit protection
on a group of underlying exposures through a nth-to-default credit
derivative (other than a first-to-default credit derivative) must
determine its risk-weighted asset amount for the derivative by applying
the RBA in section 43 (if the derivative qualifies for the RBA) or, if
the derivative does not qualify for the RBA, by setting its risk-
weighted asset amount for the derivative equal to the product of:
(A) The protection amount of the derivative;
(B) 12.5; and
(C) The sum of the risk-based capital requirements (K) of the
individual underlying exposures (as calculated under Table 2 and
excluding the n-1 underlying exposures with the lowest Ks), up to a
maximum of 100 percent.
Section 43. Ratings-Based Approach (RBA)
(a) Eligibility requirements for use of the RBA--(1) Originating
[bank]. An originating [bank] must use the RBA to calculate its risk-
based capital requirement for a securitization exposure if the exposure
has two or more external ratings or an inferred rating based on two or
more external ratings (and may not use the RBA if the exposure has
fewer than two external ratings or an inferred rating based on fewer
than two external ratings).
(2) Investing [bank]. An investing [bank] must use the RBA to
calculate its risk-based capital requirement for a securitization
exposure if the exposure has one or more external or inferred ratings
(and may not use the RBA if the exposure has no external or inferred
rating).
(b) Ratings-based approach. (1) A [bank] must determine the risk-
weighted asset amount for a securitization exposure by multiplying the
amount of the exposure (as defined in paragraph (e) of section 42) by
the appropriate risk weight provided in the tables in this section.
(2) The applicable rating of a securitization exposure that has
more than one external or inferred rating is the lowest rating.
(3) A [bank] must apply the risk weights in Table 6 when the
securitization exposure's external or inferred rating represents a
long-term credit rating, and must apply the risk weights in Table 7
when the securitization exposure's external or inferred rating
represents a short-term credit rating.
(i) A [bank] must apply the risk weights in column 1 of Table 6 or
7 to the securitization exposure if:
(A) N (as calculated under paragraph (e)(6) of section 45) is 6 or
more (for
[[Page 55939]]
purposes of this section 43 only, if the notional number of underlying
exposures is 25 or more or if all of the underlying exposures are
retail exposures, a [bank] may assume that N is 6 or more unless the
[bank] knows or has reason to know that N is less than 6); and
(B) The securitization exposure is a senior securitization
exposure.
(ii) A [bank] must apply the risk weights in column 3 of Table 6 or
7 to the securitization exposure if N is less than 6, regardless of the
seniority of the securitization exposure.
(iii) Otherwise, a [bank] must apply the risk weights in column 2
of Table 6 or 7.
Table 6.--Long-Term Credit Rating Risk Weights Under RBA and IAA
----------------------------------------------------------------------------------------------------------------
Column 1 Column 2 Column 3
--------------------------------------------------------
Risk weights for Risk weights for
senior non-senior Risk weights for
Applicable rating (illustrative rating example) securitization securitization securitization
exposures backed exposures backed exposures backed
by granular pools by granular pools by non-granular
(percent) (percent) pools (percent)
----------------------------------------------------------------------------------------------------------------
Highest investment grade (for example, AAA)............ 7 12 20
Second highest investment grade (for example, AA)...... 8 15 25
Third-highest investment grade--positive designation 10 18 35
(for example, A+).....................................
Third-highest investment grade--(for example, A)....... 12 20 .................
Third-highest investment grade-- negative designation 20 35 .................
(for example, A-).....................................
-------------------------------------
Lowest investment grade--positive designation (for 35 50
example, BBB+)........................................
Lowest investment grade (for example, BBB)............. 60 75
--------------------------------------------------------
Lowest investment grade--negative designation (for
example, BBB-)........................................ 100
--------------------------------------------------------
One category below investment grade--positive
designation (for example, BB+)........................ 250
One category below investment grade (for example, BB).. 425
One category below investment grade--negative
designation (for example, BB-)........................ 650
More than one category below investment grade.......... Deduction from tier 1 and tier 2 capital.
----------------------------------------------------------------------------------------------------------------
Table 7.--Short-Term Credit Rating Risk Weights Under RBA and IAA
----------------------------------------------------------------------------------------------------------------
Column 1 Column 2 Column 3
--------------------------------------------------------
Risk weights for Risk weights for
senior non-senior Risk weights for
Applicable Rating (illustrative rating example) securitization securitization securitization
exposures backed exposures backed exposures backed
by granular pools by granular pools by non-granular
(percent) (percent) pools (percent)
----------------------------------------------------------------------------------------------------------------
Highest investment grade (for example, A1)............. 7 12 20
Second highest investment grade (for example, A2)...... 12 20 35
Third highest investment grade (for example, A3)....... 60 75 75
All other ratings...................................... Deduction from tier 1 and tier 2 capital.
----------------------------------------------------------------------------------------------------------------
Section 44. Internal Assessment Approach (IAA)
(a) Eligibility requirements. A [bank] may apply the IAA to
calculate the risk-weighted asset amount for a securitization exposure
that the [bank] has to an ABCP program (such as a liquidity facility or
credit enhancement) if the [bank], the ABCP program, and the exposure
qualify for use of the IAA.
(1) [Bank] qualification criteria. A [bank] qualifies for use of
the IAA if the [bank] has received the prior written approval of the
[AGENCY]. To receive such approval, the [bank] must demonstrate to the
[AGENCY]'s satisfaction that the [bank]'s internal assessment process
meets the following criteria:
(i) The [bank]'s internal credit assessments of securitization
exposures must be based on publicly available rating criteria used by
an NRSRO.
(ii) The [bank]'s internal credit assessments of securitization
exposures used for risk-based capital purposes must be consistent with
those used in the [bank]'s internal risk management process, management
information reporting systems, and capital adequacy assessment process.
(iii) The [bank]'s internal credit assessment process must have
sufficient granularity to identify gradations of risk. Each of the
[bank]'s internal credit assessment categories must correspond to an
external rating of an NRSRO.
(iv) The [bank]'s internal credit assessment process, particularly
the stress test factors for determining credit enhancement
requirements, must be at least as conservative as the most conservative
of the publicly available rating criteria of the NRSROs that have
provided external ratings to the commercial paper issued by the ABCP
program.
(A) Where the commercial paper issued by an ABCP program has an
external rating from two or more NRSROs and the different NRSROs'
benchmark stress factors require different levels of credit enhancement
to achieve the same external rating equivalent, the [bank] must apply
the NRSRO stress factor that requires the highest level of credit
enhancement.
(B) If one of the NRSROs that provides an external rating to the
ABCP program's commercial paper changes its methodology (including
stress factors), the [bank] must consider the NRSRO's revised rating
methodology in evaluating whether the internal credit assessments
assigned by the [bank] to
[[Page 55940]]
securitization exposures must be revised.
(v) The [bank] must have an effective system of controls and
oversight that ensures compliance with these operational requirements
and maintains the integrity and accuracy of the internal credit
assessments. The [bank] must have an internal audit function
independent from the ABCP program business line and internal credit
assessment process that assesses at least annually whether the controls
over the internal credit assessment process function as intended.
(vi) The [bank] must review and update each internal credit
assessment whenever new material information is available, but no less
frequently than annually.
(vii) The [bank] must validate its internal credit assessment
process on an ongoing basis and at least annually.
(2) ABCP-program qualification criteria. An ABCP program qualifies
for use of the IAA if the ABCP program meets the following criteria:
(i) All commercial paper issued by the ABCP program must have an
external rating.
(ii) The ABCP program must have robust credit and investment
guidelines (that is, underwriting standards).
(iii) The ABCP program must perform a detailed credit analysis of
the asset sellers' risk profiles.
(iv) The ABCP program's underwriting policy must establish minimum
asset eligibility criteria that include the prohibition of the purchase
of assets that are significantly past due or defaulted, as well as
limitations on concentration to individual obligor or geographic area
and the tenor of the assets to be purchased.
(v) The aggregate estimate of loss on an asset pool that the ABCP
program is considering purchasing must consider all sources of
potential risk, such as credit and dilution risk.
(vi) The ABCP program must incorporate structural features into
each purchase of assets to mitigate potential credit deterioration of
the underlying exposures. Such features may include wind-down triggers
specific to a pool of underlying exposures.
(3) Exposure qualification criteria. A securitization exposure
qualifies for use of the IAA if the [bank] initially rated the exposure
at least the equivalent of investment grade.
(b) Mechanics. A [bank] that elects to use the IAA to calculate the
risk-based capital requirement for any securitization exposure must use
the IAA to calculate the risk-based capital requirements for all
securitization exposures that qualify for the IAA approach. Under the
IAA, a [bank] must map its internal assessment of such a securitization
exposure to an equivalent external rating from an NRSRO. Under the IAA,
a [bank] must determine the risk-weighted asset amount for such a
securitization exposure by multiplying the amount of the exposure (as
defined in paragraph (e) of section 42) by the appropriate risk weight
in the RBA tables in paragraph (b) of section 43.
Section 45. Supervisory Formula Approach (SFA)
(a) Eligibility requirements. A [bank] may use the SFA to determine
its risk-based capital requirement for a securitization exposure only
if the [bank] can calculate on an ongoing basis each of the SFA
parameters in paragraph (e) of this section.
(b) Mechanics. Under the SFA, a [bank] must determine the risk-
weighted asset amount for a securitization exposure by multiplying the
SFA risk-based capital requirement for the exposure (as determined in
paragraph (c) of this section) by 12.5. If the SFA risk weight for a
securitization exposure is 1,250 percent or greater, however, the
[bank] must deduct the exposure from total capital under paragraph (c)
of section 42 rather than risk weight the exposure. The SFA risk weight
for a securitization exposure is equal to 1,250 percent multiplied by
the ratio of the securitization exposure's SFA risk-based capital
requirement to the amount of the securitization exposure (as defined in
paragraph (e) of section 42).
(c) The SFA risk-based capital requirement. The SFA risk-based
capital requirement for a securitization exposure is UE multiplied by
TP multiplied by the greater of:
(1) 0.0056 * T; or
(2) S[L+T] - S[L].
(d) The supervisory formula:
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(11) In these expressions, [beta][Y; a, b] refers to the cumulative
beta distribution with parameters a and b evaluated at Y. In the case
where N = 1 and EWALGD = 100 percent, S[Y] in formula (1) must be
calculated with K[Y] set equal to the product of KIRB and Y,
and d set equal to 1-KIRB.
(e) SFA Parameters--(1) Amount of the underlying exposures (UE). UE
is the EAD of any underlying wholesale and retail exposures (including
the amount of any funded spread accounts, cash collateral accounts, and
other similar funded credit enhancements) plus the amount of any
underlying exposures that are securitization exposures (as defined in
paragraph (e) of section 42) plus the adjusted carrying value of any
underlying equity exposures (as defined in paragraph (b) of section
51).
(2) Tranche percentage (TP). TP is the ratio of the amount of the
[bank]'s securitization exposure to the amount of the tranche that
contains the securitization exposure.
(3) Capital requirement on underlying exposures (KIRB).
(i) KIRB is the ratio of:
(A) The sum of the risk-based capital requirements for the
underlying exposures plus the expected credit losses of the underlying
exposures (as determined under this appendix as if the underlying
exposures were directly held by the [bank]); to
(B) UE.
(ii) The calculation of KIRB must reflect the effects of
any credit risk mitigant applied to the underlying exposures (either to
an individual underlying exposure, a group of underlying exposures, or
to the entire pool of underlying exposures).
(iii) All assets related to the securitization are treated as
underlying exposures, including assets in a reserve account (such as a
cash collateral account).
(4) Credit enhancement level (L). (i) L is the ratio of:
(A) The amount of all securitization exposures subordinated to the
tranche that contains the [bank]'s securitization exposure; to (B) UE.
(ii) [Bank]s must determine L before considering the effects of any
tranche-specific credit enhancements.
(iii) Any gain-on-sale or CEIO associated with the securitization
may not be included in L.
(iv) Any reserve account funded by accumulated cash flows from the
underlying exposures that is subordinated to the tranche in question
may be included in the numerator and denominator of L to the extent
cash has accumulated in the account. Unfunded reserve accounts (that
is, reserve accounts that are to be funded from future cash flows from
the underlying exposures) may not be included in the calculation of L.
(v) In some cases, the purchase price of receivables will reflect a
discount that provides credit enhancement (for example, first loss
protection) for all or certain tranches of the securitization. When
this arises, L should be calculated inclusive of this discount if the
discount provides credit enhancement for the securitization exposure.
(5) Thickness of tranche (T). T is the ratio of:
(i) The amount of the tranche that contains the [bank]'s
securitization exposure; to
(ii) UE.
(6) Effective number of exposures (N). (i) Unless the [bank] elects
to use the formula provided in paragraph (f),
[GRAPHIC] [TIFF OMITTED] TP25SE06.071
where EADi represents the EAD associated with the ith
instrument in the pool of underlying exposures.
(ii) Multiple exposures to one obligor must be treated as a single
underlying exposure.
(iii) In the case of a re-securitization (that is, a securitization
in which some or all of the underlying exposures are themselves
securitization exposures), the [bank] must treat each underlying
exposure as a single underlying exposure and must not look through to
the originally securitized underlying exposures.
(7) Exposure-weighted average loss given default (EWALGD). EWALGD
is calculated as:
[GRAPHIC] [TIFF OMITTED] TP25SE06.072
where LGDi represents the average LGD associated with all
exposures to the ith obligor. In the case of a re-
securitization, an LGD of 100 percent must be assumed for the
underlying exposures that are themselves securitization exposures.
(f) Simplified method for computing N and EWALGD. (1) If all
underlying exposures of a securitization are retail exposures, a [bank]
may apply the SFA using the following simplifications:
(i) h = 0; and
(ii) v = 0.
(2) Under the conditions in paragraphs (f)(3) and (f)(4), a [bank]
may employ a simplified method for calculating N and EWALGD.
(3) If C1 is no more than 0.03, a [bank] may set EWALGD
= 0.50 and N equal to the following amount:
[[Page 55942]]
[GRAPHIC] [TIFF OMITTED] TP25SE06.073
Where:
(i) Cm is the ratio of the sum of the amounts of the `m'
largest underlying exposures to UE; and
(ii) The level of m is to be selected by the [bank].
(4) Alternatively, if only C1 is available and
C1 is no more than 0.03, the [bank] may set EWALGD = 0.50
and N = 1/C1.
Section 46. Recognition of Credit Risk Mitigants for Securitization
Exposures
(a) General. An originating [bank] that has obtained a credit risk
mitigant to hedge its securitization exposure to a synthetic or
traditional securitization that satisfies the operational criteria in
section 41 may recognize the credit risk mitigant, but only as provided
in this section. An investing [bank] that has obtained a credit risk
mitigant to hedge a securitization exposure may recognize the credit
risk mitigant, but only as provided in this section. A [bank] that has
used the RBA in section 43 or the IAA in section 44 to calculate its
risk-based capital requirement for a securitization exposure whose
external or inferred rating (or equivalent internal rating under the
IAA) reflects the benefits of a particular credit risk mitigant
provided to the associated securitization or that supports some or all
of the underlying exposures may not use the credit risk mitigation
rules in this section to further reduce its risk-based capital
requirement for the exposure to reflect that credit risk mitigant.
(b) Collateral--(1) Rules of recognition. A [bank] may recognize
financial collateral in determining the [bank]'s risk-based capital
requirement for a securitization exposure as follows. The [bank]'s
risk-based capital requirement for the collateralized securitization
exposure is equal to the risk-based capital requirement for the
securitization exposure as calculated under the RBA in section 43 or
the SFA in section 45 multiplied by the ratio of adjusted exposure
amount (E*) to original exposure amount (E), where:
(i) E* = max {0, [E-C x (1-Hs-Hfx)]{time} ;
(ii) E = the amount of the securitization exposure calculated under
paragraph (e) of section 42;
(iii) C = the current market value of the collateral;
(iv) Hs = the haircut appropriate to the collateral type; and
(v) Hfx = the haircut appropriate for any currency mismatch between
the collateral and the exposure.
(2) Mixed collateral. Where the collateral is a basket of different
asset types or a basket of assets denominated in different currencies,
the haircut on the basket will be
[GRAPHIC] [TIFF OMITTED] TP25SE06.081
where ai is the current market value of the asset in the
basket divided by the current market value of all assets in the basket
and Hi is the haircut applicable to that asset.
(3) Standard supervisory haircuts. Unless a [bank] qualifies for
use of and uses own-estimates haircuts in paragraph (b)(4) of this
section:
(i) A [bank] must use the collateral type haircuts (Hs) in Table 3;
(ii) A [bank] must use a currency mismatch haircut (Hfx) of 8
percent if the exposure and the collateral are denominated in different
currencies;
(iii) A [bank] must multiply the supervisory haircuts obtained in
paragraphs (b)(3)(i) and (ii) by the square root of 6.5 (which equals
2.549510); and
(iv) A [bank] must adjust the supervisory haircuts upward on the
basis of a holding period longer than 65 business days where and as
appropriate to take into account the illiquidity of the collateral.
(4) Own estimates for haircuts. With the prior written approval of
the [AGENCY], a [bank] may calculate haircuts using its own internal
estimates of market price volatility and foreign exchange volatility,
subject to the provisions of paragraph (a)(2)(iii) of section 32. The
minimum holding period (TM) for securitization exposures is
65 business days.
(c) Guarantees and credit derivatives--(1) Limitations on
recognition. A [bank] may only recognize an eligible guarantee or
eligible credit derivative provided by an eligible securitization
guarantor in determining the [bank]'s risk-based capital requirement
for a securitization exposure.
(2) ECL for securitization exposures. When a [bank] recognizes an
eligible guarantee or eligible credit derivative provided by an
eligible securitization guarantor in determining the [bank]'s risk-
based capital requirement for a securitization exposure, the [bank]
must also:
(i) Calculate ECL for the exposure using the same risk parameters
that it uses for calculating the risk-weighted asset amount of the
exposure as described in paragraph (c)(3) of this section; and
(ii) Add the exposure's ECL to the [bank]'s total ECL.
(3) Rules of recognition. A [bank] may recognize an eligible
guarantee or eligible credit derivative provided by an eligible
securitization guarantor in determining the [bank]'s risk-based capital
requirement for the securitization exposure as follows:
(i) Full coverage. If the protection amount of the eligible
guarantee or eligible credit derivative equals or exceeds the amount of
the securitization exposure, then the [bank] may set the risk-weighted
asset amount for the securitization exposure equal to the risk-weighted
asset amount for a direct exposure to the eligible securitization
guarantor (as determined in the wholesale risk weight function
described in section 31), using the [bank]'s PD for the guarantor, the
[bank]'s ELGD and LGD for the guarantee or credit derivative, and an
EAD equal to the amount of the securitization exposure (as determined
in paragraph (e) of section 42).
(ii) Partial coverage. If the protection amount of the eligible
guarantee or eligible credit derivative is less than the amount of the
securitization exposure, then the [bank] may set the risk-weighted
asset amount for the securitization exposure equal to the sum of:
(A) Covered portion. The risk-weighted asset amount for a direct
exposure to the eligible securitization guarantor (as determined in the
wholesale risk weight function described in section 31), using the
[bank]'s PD for the guarantor, the [bank]'s ELGD and LGD for the
guarantee or credit derivative, and an EAD equal to the protection
amount of the credit risk mitigant; and
(B) Uncovered portion. (1) 1.0 minus (the protection amount of the
eligible guarantee or eligible credit derivative divided by the amount
of the securitization exposure); multiplied by
(2) The risk-weighted asset amount for the securitization exposure
without the credit risk mitigant (as determined in sections 42-45).
[[Page 55943]]
(4) Mismatches. For any hedged securitization exposure, the [bank]
must make applicable adjustments to the protection amount as required
in paragraphs (d), (e), and (f) of section 33.
Section 47. Risk-Based Capital Requirement for Early Amortization
Provisions
(a) General. (1) An originating [bank] must hold risk-based capital
against the sum of the originating [bank]'s interest and the investors'
interest in a securitization that:
(i) Includes one or more underlying exposures in which the borrower
is permitted to vary the drawn amount within an agreed limit under a
line of credit; and
(ii) Contains an early amortization provision.
(2) For securitizations described in paragraph (a)(1) of this
section, an originating [bank] must calculate the risk-based capital
requirement for the originating [bank]'s interest under sections 42-45,
and the risk-based capital requirement for the investors' interest
under paragraph (b) of this section.
(b) Risk-weighted asset amount for investors' interest. The
originating [bank]'s risk-weighted asset amount for the investors'
interest in the securitization is equal to the product of the following
four quantities:
(1) The investors' interest EAD;
(2) The appropriate conversion factor in paragraph (c) of this
section;
(3) Kirb (as defined in paragraph (e)(3) of section 45);
and
(4) 12.5.
(c) Conversion factor. To calculate the appropriate conversion
factor discussed in paragraph (b)(2) of this section, a [bank] must use
Table 8 for a securitization that contains a controlled early
amortization provision and must use Table 9 for a securitization that
contains a non-controlled early amortization provision. A [bank] must
use the ``uncommitted'' column of Tables 8 and 9 if all or
substantially all of the underlying exposures of the securitization are
unconditionally cancelable by the [bank] to the fullest extent
permitted by Federal law. Otherwise, a [bank] must use the
``committed'' column of the tables. To calculate the trapping point
described in the tables, a [bank] must divide the three-month excess
spread level of the securitization by the excess spread trapping point
in the securitization structure.\10\
Table 8.--Controlled Early Amortization Provisions
------------------------------------------------------------------------
Uncommitted Committed
------------------------------------------------------------------------
Retail Credit Lines............ 3-month average excess 90% CF.
spread Conversion
Factor (CF).
133.33% of trapping
point or more 0% CF.
less than 133.33% to
100% of trapping
point 1% CF.
less than 100% to 75%
of trapping point 2%
CF.
less than 75% to 50%
of trapping point 10%
CF.
less than 50% to 25%
of trapping point 20%
CF.
less than 25% of
trapping point 40% CF.
Non-retail Credit Lines........ 90% CF................ 90% CF
------------------------------------------------------------------------
Table 9.--Non-Controlled Early Amortization Provisions
------------------------------------------------------------------------
Uncommitted Committed
------------------------------------------------------------------------
Retail Credit Lines............ 3-month average excess 100% CF.
spread Conversion
Factor (CF).
133.33% of trapping
point or more 0% CF.
less than 133.33% to
100% of trapping
point 5% CF.
less than 100% to 75%
of trapping point 15%
CF.
less than 75% to 50%
of trapping point 50%
CF.
less than 50% of
trapping point 100%
CF.
Non-retail Credit Lines........ 100% CF............... 100% CF
------------------------------------------------------------------------
Part VI. Risk-Weighted Assets for Equity Exposures
Section 51. Introduction and Exposure Measurement
(a) General. To calculate its risk-weighted asset amounts for
equity exposures that are not equity exposures to investment funds, a
[bank] may apply either the Simple Risk Weight Approach (SRWA) in
section 52 or, if it qualifies to do so, the Internal Models Approach
(IMA) in section 53. A [bank] must use the look-through approaches in
section 54 to calculate its risk-weighted asset amounts for equity
exposures to investment funds.
(b) Adjusted carrying value. For purposes of this part, the
``adjusted carrying value'' of an equity exposure is:
(1) For the on-balance sheet component of an equity exposure, the
[bank]'s carrying value of the exposure reduced by any unrealized gains
on the exposure that are reflected in such carrying value but excluded
from the [bank]'s tier 1 and tier 2 capital; and
(2) For the off-balance sheet component of an equity exposure, the
effective notional principal amount of the exposure, the size of which
is equivalent to a hypothetical on-balance sheet position in the
underlying equity instrument that would evidence the same change in
fair value (measured in dollars) for a given small change in the price
of the underlying equity instrument, minus the adjusted carrying value
of the on-balance sheet component of the exposure as calculated in
paragraph (b)(1) of this section.
---------------------------------------------------------------------------
\10\ In securitizations that do not require excess spread to be
trapped, or that specify trapping points based primarily on
performance measures other than the three-month average excess
spread, the excess spread trapping point is 4.5 percent.
---------------------------------------------------------------------------
[[Page 55944]]
Section 52. Simple Risk Weight Approach (SRWA)
(a) In general. Under the SRWA, a [bank]'s aggregate risk-weighted
asset amount for its equity exposures is equal to the sum of the risk-
weighted asset amounts for each of the [bank]'s individual equity
exposures (other than equity exposures to an investment fund) as
determined in this section and the risk-weighted asset amounts for each
of the [bank]'s individual equity exposures to an investment fund as
determined in section 54.
(b) SRWA computation for individual equity exposures. A [bank] must
determine the risk-weighted asset amount for an individual equity
exposure (other than an equity exposure to an investment fund) by
multiplying the adjusted carrying value of the equity exposure or the
effective portion and ineffective portion of a hedge pair (as defined
in paragraph (c) of this section) by the lowest applicable risk weight
in this paragraph (b).
(1) 0 percent risk weight equity exposures. An equity exposure to
an entity whose credit exposures are exempt from the 0.03 percent PD
floor in paragraph (d)(2) of section 31 is assigned a 0 percent risk
weight.
(2) 20 percent risk weight equity exposures. An equity exposure to
a Federal Home Loan Bank or Farmer Mac that is not publicly traded and
is held as a condition of membership in that entity is assigned a 20
percent risk weight.
(3) 100 percent risk weight equity exposures. The following equity
exposures are assigned a 100 percent risk weight:
(i) Community development equity exposures. An equity exposure that
qualifies as a community development investment under 12 U.S.C.
24(Eleventh), excluding equity exposures to an unconsolidated small
business investment company and equity exposures held through a
consolidated small business investment company described in section 302
of the Small Business Investment Act of 1958 (15 U.S.C. 682).
(ii) Certain equity exposures to a Federal Home Loan Bank and
Farmer Mac. An equity exposure to a Federal Home Loan Bank or Farmer
Mac that is not assigned a 20 percent risk weight.
(iii) Effective portion of hedge pairs. The effective portion of a
hedge pair.
(iv) Non-significant equity exposures. Equity exposures to the
extent that the aggregate adjusted carrying value of the exposures does
not exceed 10 percent of the [bank]'s tier 1 capital plus tier 2
capital.
(A) To compute the aggregate adjusted carrying value of a [bank]'s
equity exposures for purposes of this paragraph (b)(3)(iv), the [bank]
may exclude equity exposures described in paragraphs (b)(1), (b)(2),
and (b)(3)(i), (ii), and (iii) of this section, the equity exposure in
a hedge pair with the smaller adjusted carrying value, and a proportion
of each equity exposure to an investment fund equal to the proportion
of the assets of the investment fund that are not equity exposures. If
a [bank] does not know the actual holdings of the investment fund, the
[bank] may calculate the proportion of the assets of the fund that are
not equity exposures based on the terms of the prospectus, partnership
agreement, or similar contract that defines the fund's permissible
investments. If the sum of the investment limits for all exposure
classes within the fund exceeds 100 percent, the [bank] must assume for
purposes of this paragraph (b)(3)(iv) that the investment fund invests
to the maximum extent possible in equity exposures.
(B) When determining which of a [bank]'s equity exposures qualify
for a 100 percent risk weight under this paragraph, a [bank] must first
include equity exposures to unconsolidated small business investment
companies or held through consolidated small business investment
companies described in section 302 of the Small Business Investment Act
of 1958 (15 U.S.C. 682) and then must include publicly traded equity
exposures (including those held indirectly through investment funds)
and then must include non-publicly traded equity exposures (including
those held indirectly through investment funds).
(4) 300 percent risk weight equity exposures. A publicly traded
equity exposure (including the ineffective portion of a hedge pair) is
assigned a 300 percent risk weight.
(5) 400 percent risk weight equity exposures. An equity exposure
that is not publicly traded is assigned a 400 percent risk weight.
(c) Hedge transactions--(1) Hedge pair. A hedge pair is two equity
exposures that form an effective hedge so long as each equity exposure
is publicly traded or has a return that is primarily based on a
publicly traded equity exposure.
(2) Effective hedge. Two equity exposures form an effective hedge
if the exposures either have the same remaining maturity or each have a
remaining maturity of at least three months; the hedge relationship is
formally documented in a prospective manner (that is, before the [bank]
acquires at least one of the equity exposures); the documentation
specifies the measure of effectiveness (E) the [bank] will use for the
hedge relationship throughout the life of the transaction; and the
hedge relationship has an E greater than or equal to 0.8. A [bank] must
measure E at least quarterly and must use one of three alternative
measures of E:
(i) Under the dollar-offset method of measuring effectiveness, the
[bank] must determine the ratio of value change (RVC), that is, the
ratio of the cumulative sum of the periodic changes in value of one
equity exposure to the cumulative sum of the periodic changes in the
value of the other equity exposure. If RVC is positive, the hedge is
not effective and E = 0. If RVC is negative and greater than or equal
to -1 (that is, between zero and -1), then E equals the absolute value
of RVC. If RVC is negative and less than -1, then E equals 2 plus RVC.
(ii) Under the variability-reduction method of measuring
effectiveness:
[GRAPHIC] [TIFF OMITTED] TP25SE06.074
(A) Xt = At - Bt;
(B) At the value at time t of one exposure in a hedge
pair; and
(C) Bt the value at time t of the other exposure in a
hedge pair.
(iii) Under the regression method of measuring effectiveness, E
equals the coefficient of determination of a regression in which the
change in value of one exposure in a hedge pair is the dependent
variable and the change in value of the other exposure in a hedge pair
is the independent variable.
(3) The effective portion of a hedge pair is E multiplied by the
greater of the adjusted carrying values of the equity exposures forming
a hedge pair.
(4) The ineffective portion of a hedge pair is (1-E) multiplied by
the greater of the adjusted carrying values of the equity exposures
forming a hedge pair.
Section 53. Internal Models Approach (IMA)
This section describes the two ways that a [bank] may calculate its
risk-weighted asset amount for equity exposures using the IMA. A [bank]
may model publicly traded and non-publicly traded equity exposures (in
accordance with paragraph (b) of this section) or model only publicly
traded equity exposure (in accordance with paragraph (c) of this
section).
(a) Qualifying criteria. To qualify to use the IMA to calculate
risk-based
[[Page 55945]]
capital requirements for equity exposures, a [bank] must receive prior
written approval from the [AGENCY]. To receive such approval, the
[bank] must demonstrate to the [AGENCY]'s satisfaction that the [bank]
meets the following criteria:
(1) The [bank] must have a model that:
(i) Assesses the potential decline in value of its modeled equity
exposures;
(ii) Is commensurate with the size, complexity, and composition of
the [bank]'s modeled equity exposures; and
(iii) Adequately captures both general market risk and
idiosyncratic risk.
(2) The [bank]'s model must produce an estimate of potential losses
for its modeled equity exposures that is no less than the estimate of
potential losses produced by a VaR methodology employing a 99.0
percent, one-tailed confidence interval of the distribution of
quarterly returns for a benchmark portfolio of equity exposures
comparable to the [bank]'s modeled equity exposures using a long-term
sample period.
(3) The number of risk factors and exposures in the sample and the
data period used for quantification in the [bank]'s model and
benchmarking exercise must be sufficient to provide confidence in the
accuracy and robustness of the [bank]'s estimates.
(4) The [bank]'s model and benchmarking process must incorporate
data that are relevant in representing the risk profile of the [bank]'s
modeled equity exposures, and must include data from at least one
equity market cycle containing adverse market movements relevant to the
risk profile of the [bank]'s modeled equity exposures. If the [bank]'s
model uses a scenario methodology, the [bank] must demonstrate that the
model produces a conservative estimate of potential losses on the
[bank]'s modeled equity exposures over a relevant long-term market
cycle. If the [bank] employs risk factor models, the [bank] must
demonstrate through empirical analysis the appropriateness of the risk
factors used.
(5) Daily market prices must be available for all modeled equity
exposures, either direct holdings or proxies.
(6) The [bank] must be able to demonstrate, using theoretical
arguments and empirical evidence, that any proxies used in the modeling
process are comparable to the [bank]'s modeled equity exposures and
that the [bank] has made appropriate adjustments for differences. The
[bank] must derive any proxies for its modeled equity exposures and
benchmark portfolio using historical market data that are relevant to
the [bank]'s modeled equity exposures and benchmark portfolio (or,
where not, must use appropriately adjusted data), and such proxies must
be robust estimates of the risk of the [bank]'s modeled equity
exposures.
(b) Risk-weighted assets calculation for a [bank] modeling publicly
traded and non-publicly traded equity exposures. If a [bank] models
publicly traded and non-publicly traded equity exposures, the [bank]'s
aggregate risk-weighted asset amount for its equity exposures is equal
to the sum of:
(1) The risk-weighted asset amount of each equity exposure that
qualifies for a 0-100 percent risk weight under paragraphs (b)(1)
through (b)(3)(ii) of section 52 (as determined under section 52) and
each equity exposure to an investment fund (as determined under section
54); and
(2) The greater of:
(i) The estimate of potential losses on the [bank]'s equity
exposures (other than equity exposures referenced in paragraph (b)(1)
of this section) generated by the [bank]'s internal equity exposure
model multiplied by 12.5; or
(ii) The sum of:
(A) 200 percent multiplied by the aggregate adjusted carrying value
of the [bank]'s publicly traded equity exposures that do not belong to
a hedge pair, do not qualify for a 0-100 percent risk weight under
paragraphs (b)(1) through (b)(3)(ii) of section 52, and are not equity
exposures to an investment fund;
(B) 200 percent multiplied by the aggregate ineffective portion of
all hedge pairs; and
(C) 300 percent multiplied by the aggregate adjusted carrying value
of the [bank]'s equity exposures that are not publicly traded, do not
qualify for a 0-100 percent risk weight under paragraphs (b)(1) through
(b)(3)(ii) of section 52, and are not equity exposures to an investment
fund.
(c) Risk-weighted assets calculation for a [bank] using the IMA
only for publicly traded equity exposures. If a [bank] models only
publicly traded equity exposures, the [bank]'s aggregate risk-weighted
asset amount for its equity exposures is equal to the sum of:
(1) The risk-weighted asset amount of each equity exposure that
qualifies for a 0-100 percent risk weight under paragraphs (b)(1)
through (b)(3)(ii) of section 52 (as determined under section 52), each
equity exposure that qualifies for a 400 percent risk weight under
paragraph (b)(5) of section 52 (as determined under section 52), and
each equity exposure to an investment fund (as determined under section
54); and
(2) The greater of:
(i) The estimate of potential losses on the [bank]'s equity
exposures (other than equity exposures referenced in paragraph (c)(1)
of this section) generated by the [bank]'s internal equity exposure
model multiplied by 12.5; or
(ii) The sum of:
(A) 200 percent multiplied by the aggregate adjusted carrying value
of the [bank]'s publicly traded equity exposures that do not belong to
a hedge pair, do not qualify for a 0-100 percent risk weight under
paragraphs (b)(1) through (b)(3)(ii) of section 52, and are not equity
exposures to an investment fund; and
(B) 200 percent multiplied by the aggregate ineffective portion of
all hedge pairs.
Section 54. Equity Exposures to Investment Funds
(a) Available approaches. A [bank] must determine the risk-weighted
asset amount of an equity exposure to an investment fund under the Full
Look-Through Approach in paragraph (b) of this section, the Simple
Modified Look-Through Approach in paragraph (c) of this section, or the
Alternative Modified Look-Through Approach in paragraph (d) of this
section unless the exposure would meet the requirements for a community
development equity exposure in paragraph (b)(3)(i) of section 52. The
risk-weighted asset amount of such an equity exposure to an investment
fund would be its adjusted carrying value. If an equity exposure to an
investment fund is part of a hedge pair, a [bank] may use the
ineffective portion of the hedge pair as determined under paragraph (c)
of section 52 as the adjusted carrying value for the equity exposure to
the investment fund.
(b) Full look-through approach. A [bank] that is able to calculate
a risk-weighted asset amount for each exposure held by the investment
fund (as calculated under this appendix as if the exposures were held
directly by the [bank]) may set the risk-weighted asset amount of the
[bank]'s exposure to the fund equal to the greater of:
(1) The product of:
(i) The aggregate risk-weighted asset amounts of the exposures held
by the fund (as calculated under this appendix) as if the exposures
were held directly by the [bank]; and
(ii) The [bank]'s proportional ownership share of the fund; or
(2) 7 percent of the adjusted carrying value of the [bank]'s equity
exposure to the fund.
[[Page 55946]]
(c) Simple modified look-through approach. Under this approach, the
risk-weighted asset amount for a [bank]'s equity exposure to an
investment fund equals the adjusted carrying value of the equity
exposure multiplied by the greater of:
(1) The highest risk weight in Table 10 that applies to any
exposure the fund is permitted to hold under its prospectus,
partnership agreement, or similar contract that defines the fund's
permissible investments (excluding derivative contracts that are used
for hedging rather than speculative purposes and do not constitute a
material portion of the fund's exposures); or
(2) 7 percent.
Table 10.--Modified Look-Through Approaches for Equity Exposures to
Investment Funds
------------------------------------------------------------------------
Risk weight Exposure class
------------------------------------------------------------------------
0 percent.................... Sovereign exposures with a long-term
applicable external rating in the
highest investment grade rating category
and sovereign exposures of the United
States.
20 percent................... Exposures with a long-term applicable
external rating in the highest or second-
highest investment grade rating
category; exposures with a short-term
applicable external rating in the
highest investment grade rating
category; and exposures to, or
guaranteed by, depository institutions,
foreign banks (as defined in 12 CFR
211.2), or securities firms subject to
consolidated supervision and regulation
comparable to that imposed on U.S.
securities broker-dealers that are repo-
style transactions or bankers'
acceptances.
50 percent................... Exposures with a long-term applicable
external rating in the third-highest
investment grade rating category or a
short-term applicable external rating in
the second-highest investment grade
rating category.
100 percent.................. Exposures with a long-term or short-term
applicable external rating in the lowest
investment grade rating category.
200 percent.................. Exposures with a long-term applicable
external rating one rating category
below investment grade.
300 percent.................. Publicly traded equity exposures.
400 percent.................. Non-publicly traded equity exposures;
exposures with a long-term applicable
external rating two rating categories or
more below investment grade; and
exposures without an external rating
(excluding publicly traded equity
exposures).
1,250 percent................ OTC derivative contracts and exposures
that must be deducted from regulatory
capital or receive a risk weight greater
than 400 percent under this appendix.
------------------------------------------------------------------------
(d) Alternative Modified Look-Through Approach. Under this
approach, a [bank] may assign the adjusted carrying value of an equity
exposure to an investment fund on a pro rata basis to different risk
weight categories in Table 10 according to the investment limits in the
fund's prospectus, partnership agreement, or similar contract that
defines the fund's permissible investments. If the sum of the
investment limits for exposure classes within the fund exceeds 100
percent, the [bank] must assume that the fund invests to the maximum
extent permitted under its investment limits in the exposure class with
the highest risk weight under Table 10, and continues to make
investments in order of the exposure class with the next highest risk
weight under Table 10 until the maximum total investment level is
reached. If more than one exposure class applies to an exposure, the
[bank] must use the highest applicable risk weight. A [bank] may not
assign an equity exposure to an investment fund to an aggregate risk
weight of less than 7 percent. A [bank] may exclude derivative
contracts held by the fund that are used for hedging rather than
speculative purposes and do not constitute a material portion of the
fund's exposures.
Section 55. Equity Derivative Contracts
Under the IMA, in addition to holding risk-based capital against an
equity derivative contract under this part, a [bank] must hold risk-
based capital against the counterparty credit risk in the equity
derivative contract by also treating the equity derivative contract as
a wholesale exposure and computing a supplemental risk-weighted asset
amount for the contract under part IV. Under the SRWA, a [bank] may
choose not to hold risk-based capital against the counterparty credit
risk of equity derivative contracts, as long as it does so for all such
contracts. Where the equity derivative contracts are subject to a
qualified master netting agreement, a [bank] using the SRWA must either
include all or exclude all of the contracts from any measure used to
determine counterparty credit risk exposure.
Part VII. Risk-Weighted Assets for Operational Risk
Section 61. Qualification Requirements for Incorporation of Operational
Risk Mitigants
(a) Qualification to use operational risk mitigants. A [bank] may
adjust its estimate of operational risk exposure to reflect qualifying
operational risk mitigants if:
(1) The [bank]'s operational risk quantification system is able to
generate an estimate of the [bank]'s operational risk exposure (which
does not incorporate qualifying operational risk mitigants) and an
estimate of the [bank]'s operational risk exposure adjusted to
incorporate qualifying operational risk mitigants; and
(2) The [bank]'s methodology for incorporating the effects of
insurance, if the [bank] uses insurance as an operational risk
mitigant, captures through appropriate discounts to the amount of risk
mitigation:
(i) The residual term of the policy, where less than one year;
(ii) The cancellation terms of the policy, where less than one
year;
(iii) The policy's timeliness of payment;
(iv) The uncertainty of payment by the provider of the policy; and
(v) Mismatches in coverage between the policy and the hedged
operational loss event.
(b) Qualifying operational risk mitigants. Qualifying operational
risk mitigants are:
(1) Insurance that:
(i) Is provided by an unaffiliated company that has a claims
payment ability that is rated in one of the three highest rating
categories by a NRSRO;
(ii) Has an initial term of at least one year and a residual term
of more than 90 days;
(iii) Has a minimum notice period for cancellation by the provider
of 90 days;
(iv) Has no exclusions or limitations based upon regulatory action
or for the receiver or liquidator of a failed depository institution;
and
(v) Is explicitly mapped to a potential operational loss event; and
[[Page 55947]]
(2) Operational risk mitigants other than insurance for which the
[AGENCY] has given prior written approval. In evaluating an operational
risk mitigant other than insurance, [AGENCY] will consider whether the
operational risk mitigant covers potential operational losses in a
manner equivalent to holding regulatory capital.
Section 62. Mechanics of Risk-Weighted Asset Calculation
(a) If a [bank] does not qualify to use or does not have qualifying
operational risk mitigants, the [bank]'s dollar risk-based capital
requirement for operational risk is its operational risk exposure minus
eligible operational risk offsets (if any).
(b) If a [bank] qualifies to use operational risk mitigants and has
qualifying operational risk mitigants, the [bank]'s dollar risk-based
capital requirement for operational risk is the greater of:
(1) The [bank]'s operational risk exposure adjusted for qualifying
operational risk mitigants minus eligible operational risk offsets (if
any); or
(2) 0.8 multiplied by the difference between:
(i) The [bank]'s operational risk exposure; and
(ii) Eligible operational risk offsets (if any).
(c) The [bank]'s risk-weighted asset amount for operational risk
equals the [bank]'s dollar risk-based capital requirement for
operational risk determined under paragraph (a) or (b) of this section
multiplied by 12.5.
Part VIII. Disclosure
Section 71. Disclosure Requirements
(a) Each [bank] must publicly disclose each quarter its total and
tier 1 risk-based capital ratios and their components (that is, tier 1
capital, tier 2 capital, total qualifying capital, and total risk-
weighted assets).\11\
---------------------------------------------------------------------------
\11\ Other public disclosure requirements continue to apply--for
example, Federal securities law and regulatory reporting
requirements.
---------------------------------------------------------------------------
[Disclosure paragraph (b)]
[Disclosure paragraph (c)]
End of common rule.
[End of common text]
List of Subjects
12 CFR Part 3
Administrative practices and procedure, Capital, National banks,
Reporting and recordkeeping requirements, Risk.
12 CFR Part 208
Confidential business information, Crime, Currency, Federal Reserve
System, Mortgages, reporting and recordkeeping requirements,
Securities.
12 CFR Part 225
Administrative practice and procedure, Banks, banking, Federal
Reserve System, Holding companies, Reporting and recordkeeping
requirements, Securities.
12 CFR Part 325
Administrative practice and procedure, Banks, banking, Capital
Adequacy, Reporting and recordkeeping requirements, Savings
associations, State nonmember banks.
12 CFR Part 566
Capital, reporting and recordkeeping requirements, Savings
associations.
Authority and Issuance
Adoption of Common Appendix
The adoption of the proposed common rules by the agencies, as
modified by agency-specific text, is set forth below:
Department of the Treasury
Office of the Comptroller of the Currency
12 CFR Chapter I
Authority and Issuance
For the reasons stated in the common preamble, the Office of the
Comptroller of the Currency proposes to amend Part 3 of chapter I of
Title 12, Code of Federal Regulations as follows:
PART 3--MINIMUM CAPITAL RATIOS; ISSUANCE OF DIRECTIVES
1. The authority citation for part 3 continues to read as follows:
Authority: 12 U.S.C. 93a, 161, 1818, 1828(n), 1828 note, 1831n
note, 1835, 3907, and 3909.
2. New Appendix C to part 3 is added as set forth at the end of the
common preamble.
3. Appendix C to part 3 is amended as set forth below:
a. Remove ``[AGENCY]'' and add ``OCC'' in its place wherever it
appears.
b. Remove ``[bank]'' and add ``bank'' in its place wherever it
appears, and remove ``[Bank]'' and add ``Bank'' in its place wherever
it appears.
c. Remove ``[Appendix -- to Part -- ]'' and add ``Appendix C to
Part 3'' in its place wherever it appears.
d. Remove ``[the general risk-based capital rules]'' and add ``12
CFR part 3, Appendix A'' in its place wherever it appears.
e. Remove ``[the market risk rule]'' and add ``12 CFR part 3,
Appendix B'' in its place wherever it appears.
f. Remove ``[Disclosure paragraph (b)]'' and add in its place ``(b)
A bank must comply with paragraph (c) of section 71 of appendix F to
the Federal Reserve Board's Regulation Y (12 CFR part 225, appendix F)
unless it is a consolidated subsidiary of a bank holding company or
depository institution that is subject to these requirements.''
g. Remove ``[Disclosure paragraph (c)].''
Board of Governors of the Federal Reserve System
12 CFR Chapter II
Authority and Issuance
For the reasons stated in the common preamble, the Board of
Governors of the Federal Reserve System proposes to amend parts 208 and
225 of chapter II of title 12 of the Code of Federal Regulations as
follows:
PART 208--MEMBERSHIP OF STATE BANKING INSTITUTIONS IN THE FEDERAL
RESERVE SYSTEM (REGULATION H)
1. The authority citation for part 208 continues to read as
follows:
Authority: 12 U.S.C. 24, 36, 92a, 93a, 248(a), 248(c), 321-338a,
371d, 461, 481-486, 601, 611, 1814, 1816, 1818, 1820(d)(9), 1823(j),
1828(o), 1831, 1831o, 1831p-1, 1831r-1, 1835a, 1882, 2901-2907,
3105, 3310, 3331-3351, and 3906-3909; 15 U.S.C. 78b, 78l(b), 78l(g),
78l(i), 78o-4(c)(5), 78q, 78q-1, and 78w, 6801, and 6805; 31 U.S.C.
5318; 42 U.S.C. 4012a, 4104a, 4104b, 4106, and 4128.
2. New Appendix F to part 208 is added as set forth at the end of
the common preamble.
3. Appendix F to part 208 is amended as set forth below:
a. Remove ``[AGENCY]'' and add ``Board'' in its place wherever it
appears.
b. Remove ``[bank]'' and add ``bank'' in its place wherever it
appears, and remove ``[Bank]'' and add ``Bank'' in its place wherever
it appears.
c. Remove ``[Appendix -- to Part --]'' and add ``Appendix F to Part
208'' in its place wherever it appears.
d. Remove ``[the general risk-based capital rules]'' and add ``12
CFR part 208, Appendix A'' in its place wherever it appears.
e. Remove ``[the market risk rule]'' and add ``12 CFR part 208,
Appendix E'' in its place wherever it appears.
f. Remove ``[Disclosure paragraph (b)]'' and add in its place ``(b)
A bank must comply with paragraph (c) of section 71 of appendix F to
the Federal Reserve Board's Regulation Y (12 CFR part 225, appendix F)
unless it is a
[[Page 55948]]
consolidated subsidiary of a bank holding company or depository
institution that is subject to these requirements.''
g. Remove ``[Disclosure paragraph (c)].''
PART 225--BANK HOLDING COMPANIES AND CHANGE IN BANK CONTROL
(REGULATION Y)
1. The authority citation for part 225 continues to read as
follows:
Authority: 12 U.S.C. 1817(j)(13), 1818, 1828(o), 1831i, 1831p-1,
1843(c)(8), 1844(b), 1972(1), 3106, 3108, 3310, 3331-3351, 3907, and
3909; 15 U.S.C. 6801 and 6805.
2. New Appendix G to part 225 is added as set forth at the end of
the common preamble.
3. Appendix G to part 225 is amended as set forth below:
a. Remove ``[AGENCY]'' and add ``Board'' in its place wherever it
appears.
b. Remove ``[bank]'' and add in its place ``bank holding company''
wherever it appears, and remove ``[Bank]'' and add ``Bank holding
company'' in its place wherever it appears.
c. Remove ``[Appendix -- to Part --]'' and add ``Appendix G to Part
225'' in its place wherever it appears.
d. Remove ``[the general risk-based capital rules]'' and add ``12
CFR part 225, Appendix A'' in its place wherever it appears.
e. Remove ``[the market risk rule]'' and add ``12 CFR part 225,
Appendix E'' in its place wherever it appears.
f. Remove the text of section 1(b)(1)(i) and add in its place: ``Is
a U.S.-based bank holding company that has total consolidated assets
(excluding assets held by an insurance underwriting subsidiary), as
reported on the most recent year-end FR Y-9C, equal to $250 billion or
more;''.
g. Remove the text of section 1(b)(1)(iii) and add in its place:
``Has a subsidiary depository institution (as defined in 12 U.S.C.
1813) that is required, or has elected, to use 12 CFR part 3, Appendix
C, 12 CFR part 208, Appendix F, 12 CFR part 325, Appendix F, or 12 CFR
556 to calculate its risk-based capital requirements;''.
h. At the end of section 11(b)(1) add the following sentence: ``A
bank holding company also must deduct an amount equal to the minimum
regulatory capital requirement established by the regulator of any
insurance underwriting subsidiary of the holding company. For U.S.-
based insurance underwriting subsidiaries, this amount generally would
be 200 percent of the subsidiary's Authorized Control Level as
established by the appropriate state regulator of the insurance
company.''
i. Remove section 22(h)(3)(ii).
j. In section 31(e)(3), remove ``A bank may assign a risk-weighted
asset amount of zero to cash owned and held in all offices of the bank
or in transit and for gold bullion held in the bank's own vaults, or
held in another bank's vaults on an allocated basis, to the extent it
is offset by gold bullion liabilities'' and add in its place ``A bank
holding company may assign a risk-weighted asset amount of zero to cash
owned and held in all offices of subsidiary depository institutions or
in transit and for gold bullion held in either a subsidiary depository
institution's own vaults, or held in another's vaults on an allocated
basis, to the extent it is offset by gold bullion liabilities.''
k. Remove ``[Disclosure paragraph (b)].''
l. Remove ``[Disclosure paragraph (c)].''
m. In section 71, add new paragraph (b) to read as follows:
Section 71. * * *
* * * * *
(b)(1) Each consolidated bank holding company that has successfully
completed its parallel run must provide timely public disclosures each
calendar quarter of the information in tables 11.1-11.11 below. If a
significant change occurs, such that the most recent reported amounts
are no longer reflective of the bank holding company's capital adequacy
and risk profile, then a brief discussion of this change and its likely
impact must be provided as soon as practicable thereafter. Qualitative
disclosures that typically do not change each quarter (for example, a
general summary of the bank holding company's risk management
objectives and policies, reporting system, and definitions) may be
disclosed annually, provided any significant changes to these are
disclosed in the interim. Management is encouraged to provide all of
the disclosures required by this appendix in one place on the bank
holding company's public Web site.\12\ The bank holding company must
make these disclosures publicly available for each of the last three
years (that is, twelve quarters) or such shorter period since it began
its first floor period.
---------------------------------------------------------------------------
\12\ Alternatively, a bank holding company may provide the
disclosures in more than one place, as some of them may be included
in public financial reports (for example, in Management's Discussion
and Analysis included in SEC filings) or other regulatory reports.
The bank holding company must provide a summary table on its public
Web site that specifically indicates where all the disclosures may
be found (for example, regulatory report schedules, page numbers in
annual reports).
---------------------------------------------------------------------------
(2) Each bank holding company is required to have a formal
disclosure policy approved by the board of directors that addresses its
approach for determining the disclosures it makes. The policy must
address the associated internal controls and disclosure controls and
procedures. The board of directors and senior management must ensure
that appropriate verification of the disclosures takes place and that
effective internal controls and disclosure controls and procedures are
maintained. The chief financial officer of the bank holding company
must certify that the disclosures required by this appendix are
appropriate, and the board of directors and senior management are
responsible for establishing and maintaining an effective internal
control structure over financial reporting, including the disclosures
required by this appendix.
---------------------------------------------------------------------------
\13\ Entities include securities, insurance and other financial
subsidiaries, commercial subsidiaries (where permitted), significant
minority equity investments in insurance, financial and commercial
entities.
\14\ A capital deficiency is the amount by which actual
regulatory capital is less than the minimum regulatory capital
requirement.
Table 11.1.--Scope of Application
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative Disclosures........... (a) The name of the top corporate
entity in the group to which the
appendix applies.
(b) An outline of differences in the
basis of consolidation for
accounting and regulatory purposes,
with a brief description of the
entities \13\ within the group (a)
that are fully consolidated; (b)
that are deconsolidated and
deducted; (c) for which the
regulatory capital requirement is
deducted; and (d) that are neither
consolidated nor deducted (for
example, where the investment is
risk-weighted).
(c) Any restrictions, or other major
impediments, on transfer of funds
or regulatory capital within the
group.
Quantitative Disclosures.......... (d) The aggregate amount of surplus
capital of insurance subsidiaries
(whether deducted or subjected to
an alternative method) included in
the regulatory capital of the
consolidated group.
(e) The aggregate amount of capital
deficiencies \14\ in all
subsidiaries and the name(s) of
such subsidiaries.
------------------------------------------------------------------------
[[Page 55949]]
Table 11.2.--Capital Structure
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative Disclosures........... (a) Summary information on the terms
and conditions of the main features
of all capital instruments,
especially in the case of
innovative, complex or hybrid
capital instruments.
Quantitative Disclosures.......... (b) The amount of tier 1 capital,
with separate disclosure of:
Common stock/surplus;
Retained earnings;
Minority interests in the
equity of subsidiaries;
Restricted core capital
elements as defined in 12 CFR part
225, Appendix A;
Regulatory calculation
differences deducted from tier 1
capital; \15\ and
Other amounts deducted from
tier 1 capital, including goodwill
and certain intangibles.
(c) The total amount of tier 2
capital.
(d) Other deductions from
capital.\16\
(e) Total eligible capital.
------------------------------------------------------------------------
Table 11.3.--Capital Adequacy
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative Disclosures........... (a) A summary discussion of the bank
holding company's approach to
assessing the adequacy of its
capital to support current and
future activities.
Quantitative Disclosures.......... (b) Risk-weighted assets for credit
risk from:
Wholesale exposures;
Residential mortgage
exposures;
Qualifying revolving
exposures;
Other retail exposures;
Securitization exposures;
Equity exposures:
Equity exposures subject to
simple risk weight approach; and
Equity exposures subject to
internal models approach.
(c) Risk-weighted assets for market
risk as calculated under [the
market risk rule]: \17\
Standardized approach for
specific risk; and
Internal models approach
for specific risk.
(d) Risk-weighted assets for
operational risk.
(e) Total and tier 1 risk-based
capital ratios: \18\
For the top consolidated
group; and
For each DI subsidiary.
------------------------------------------------------------------------
General Qualitative Disclosure Requirement
---------------------------------------------------------------------------
\15\ Representing 50% of the amount, if any, by which total
expected credit losses as calculated within the IRB framework exceed
eligible credit reserves, which must be deducted from Tier 1
capital.
\16\ Including 50% of the amount, if any, by which total
expected credit losses as calculated within the IRB framework exceed
eligible credit reserves, which must be deducted from Tier 2
capital.
---------------------------------------------------------------------------
For each separate risk area described in tables 11.4 through 11.11,
the bank holding company must describe its risk management objectives
and policies, including:
Strategies and processes;
The structure and organization of the relevant risk
management function;
The scope and nature of risk reporting and/or measurement
systems;
Policies for hedging and/or mitigating risk and strategies
and processes for monitoring the continuing effectiveness of hedges/
mitigants.
---------------------------------------------------------------------------
\17\ Risk-weighted assets determined under [the market risk
rule] are to be disclosed only for the approaches used.
\18\ Total risk-weighted assets should also be disclosed.
Table 11.4.\19\--Credit Risk: General Disclosures
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative Disclosures........... (a) The general qualitative
disclosure requirement with respect
to credit risk (excluding
counterparty credit risk disclosed
in accordance with Table 11.6),
including:
Definitions of past due and
impaired (for accounting purposes);
Description of approaches
followed for allowances, including
statistical methods used where
applicable;
Discussion of the bank
holding company's credit risk
management policy.
Quantitative Disclosures.......... (b) Total gross credit risk
exposures,\20\ and average gross
credit risk exposures, over the
period broken down by major types
of credit exposure.\21\
(c) Geographic \22\ distribution of
exposures, broken down in
significant areas by major types of
credit exposure.
(d) Industry or counterparty type
distribution of exposures, broken
down by major types of credit
exposure.
(e) Remaining contractual maturity
breakdown (for example, one year or
less) of the whole portfolio,
broken down by major types of
credit exposure.
(f) By major industry or
counterparty type:
Amount of impaired loans;
Amount of past due loans;
\23\ Allowances; and,
Charge-offs during the
period.
(g) Amount of impaired loans and, if
available, the amount of past due
loans broken down by significant
geographic areas including, if
practical, the amounts of
allowances related to each
geographical area.\24\
(h) Reconciliation of changes in the
allowance for loan and lease
losses.\25\
------------------------------------------------------------------------
[[Page 55950]]
---------------------------------------------------------------------------
\19\ Table 4 does not include equity exposures.
\20\ That is, after accounting offsets in accordance with U.S.
GAAP (for example, FASB Interpretations 39 and 41) and without
taking into account the effects of credit risk mitigation
techniques, for example collateral and netting.
\21\ For example, banks could apply a breakdown similar to that
used for accounting purposes. Such a breakdown might, for instance,
be (a) loans, off-balance sheet commitments, and other non-
derivative off-balance sheet exposures, (b) debt securities, and (c)
OTC derivatives.
\22\ Geographical areas may comprise individual countries,
groups of countries or regions within countries. A bank holding
company might choose to define the geographical areas based on the
way the company's portfolio is geographically managed. The criteria
used to allocate the loans to geographical areas must be specified.
\23\ A bank holding company is encouraged also to provide an
analysis of the aging of past-due loans.
\24\ The portion of general allowance that is not allocated to a
geographical area should be disclosed separately.
\25\ The reconciliation should include the following: A
description of the allowance; the opening balance of the allowance;
charge-offs taken against the allowance during the period; amounts
provided (or reversed) for estimated probable loan losses during the
period; any other adjustments (for example, exchange rate
differences, business combinations, acquisitions and disposals of
subsidiaries), including transfers between allowances; and the
closing balance of the allowance. Charge-offs and recoveries that
have been recorded directly to the income statement should be
disclosed separately.
Table 11.5.--Credit Risk: Disclosures for Portfolios Subject to IRB Risk-
Based Capital Formulas
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative disclosures........... (a) Explanation and review of the:
Structure of internal
rating systems and relation between
internal and external ratings;
Use of risk parameter
estimates other than for regulatory
capital purposes;
Process for managing and
recognizing credit risk mitigation;
and
Control mechanisms for the
rating system, including discussion
of independence, accountability,
and rating systems review.
(b) Description of the internal
ratings process, provided
separately for the following:
Wholesale category;
Retail subcategories:
Residential mortgage
exposures;
Qualifying revolving
exposures; and
Other retail exposures.
For each category and subcategory
the description should include:
The types of exposure
included in the category
subcategories;
The definitions, methods
and data for estimation and
validation of PD, ELGD, LGD, and
EAD, including assumptions employed
in the derivation of these
variables.\26\
Quantitative disclosures: Risk (c) For wholesale exposures, present
assessment. the following information across a
sufficient number of PD grades
(including default) to allow for a
meaningful differentiation of
credit risk: \27\
Total EAD; \28\
Exposure-weighted average
ELGD and LGD (percentage);
Exposure weighted-average
capital requirement (K); and
Amount of undrawn
commitments and exposure-weighted
average EAD for wholesale
exposures.
For each retail subcategory, present
the disclosures outlined above
across a sufficient number of
segments to allow for a meaningful
differentiation of credit risk.
Quantitative disclosures: (d) Actual losses in the preceding
historical results. period for each category and
subcategory and how this differs
from past experience. A discussion
of the factors that impacted the
loss experience in the preceding
period--for example, has the bank
holding company experienced higher
than average default rates, loss
rates or EADs.
(e) Comparison of risk parameter
estimates against actual outcomes
over a longer period.\29\ At a
minimum, this should include
information on estimates of losses
against actual losses in the
wholesale category and each retail
subcategory over a period
sufficient to allow for a
meaningful assessment of the
performance of the internal rating
processes for each category/
subcategory.\30\ Where appropriate,
the bank holding company should
further decompose this to provide
analysis of PD, ELGD, LGD, and EAD
outcomes against estimates provided
in the quantitative risk assessment
disclosures above.\31\
------------------------------------------------------------------------
---------------------------------------------------------------------------
\26\ This disclosure does not require a detailed description of
the model in full--it should provide the reader with a broad
overview of the model approach, describing definitions of the
variables, and methods for estimating and validating those variables
set out in the quantitative risk disclosures below. This should be
done for each of the four category/subcategories. The bank holding
company should disclose any significant differences in approach to
estimating these variables within each category/subcategories.
\27\ The PD, ELGD, LGD and EAD disclosures in Table 11.5(c)
should reflect the effects of collateral, qualifying master netting
agreements, eligible guarantees and eligible credit derivatives as
defined in Part 1. Disclosure of each PD grade should include the
exposure weighted-average PD for each grade. Where a bank holding
company aggregates PD grades for the purposes of disclosure, this
should be a representative breakdown of the distribution of PD
grades used for regulatory capital purposes.
\28\ Outstanding loans and EAD on undrawn commitments can be
presented on a combined basis for these disclosures.
\29\ These disclosures are a way of further informing the reader
about the reliability of the information provided in the
``quantitative disclosures: Risk assessment'' over the long run. The
disclosures are requirements from year-end 2010; in the meantime,
early adoption is encouraged. The phased implementation is to allow
a bank holding company sufficient time to build up a longer run of
data that will make these disclosures meaningful.
\30\ This regulation is not prescriptive about the period used
for this assessment. Upon implementation, it might be expected that
a bank holding company would provide these disclosures for as long
run of data as possible--for example, if a bank holding company has
10 years of data, it might choose to disclose the average default
rates for each PD grade over that 10-year period. Annual amounts
need not be disclosed.
\31\ A bank holding company should provide this further
decomposition where it will allow users greater insight into the
reliability of the estimates provided in the ``quantitative
disclosures: Risk assessment.'' In particular, it should provide
this information where there are material differences between is
estimates of PD, ELGD, LGD or EAD compared to actual outcomes over
the long run. The bank holding company should also provide
explanations for such differences.
[[Page 55951]]
Table 11.6.--General Disclosure for Counterparty Credit Risk-Related
Exposures
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative Disclosures........... (a) The general qualitative
processes for disclosure
requirement with respect to OTC
derivatives, eligible margin loans,
and repo-style transactions,
including:
Discussion of methodology
used to assign economic capital and
credit limits for counterparty
credit exposures;
Discussion of policies and
securing collateral, valuing and
managing collateral, and
establishing credit reserves;
Discussion of the primary
types of collateral taken;
Discussion of policies with
respect to wrong-way risk
exposures; and
Discussion of the impact of
the amount of collateral the bank
would have to provide given a
credit rating downgrade.
Quantitative Disclosures.......... (b) Gross positive fair value of
contracts, netting benefits, netted
current credit exposure, collateral
held (including type, for example,
cash, government securities), and
net unsecured credit exposure.\32\
Also report measures for EAD used
for regulatory capital for these
transactions, the notional value of
credit derivative hedges purchased
for counterparty credit risk
protection, and the distribution of
current credit exposure by types of
credit exposure.\33\
(c) Notional amount of purchased and
sold credit derivatives, segregated
between use for the institution's
own credit portfolio, as well as in
its intermediation activities,
including the distribution of the
credit derivative products used,
broken down further by protection
bought and sold within each product
group.
(d) The estimate of alpha if the
bank holding company has received
supervisory approval to estimate
alpha.
------------------------------------------------------------------------
---------------------------------------------------------------------------
\32\ Net unsecured credit exposure is the credit exposure after
considering both the benefits from legally enforceable netting
agreements and collateral arrangements without taking into account
haircuts for price volatility, liquidity, etc.
\33\ This may include interest rate derivative contracts,
foreign exchange derivative contracts, equity derivative contracts,
credit derivatives, commodity or other derivative contracts, repo-
style transactions, and eligible margin loans.
Table 11.7.--Credit Risk Mitigation \34, 35, 36\
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative Disclosure............ (a) The general qualitative
disclosure requirement with respect
to credit risk mitigation
including:
Policies and processes for,
and an indication of the extent to
which the bank holding company
uses, on- and off-balance sheet
netting;
Policies and processes for
collateral valuation and
management;
A description of the main
types of collateral taken by the
bank holding company;
The main type of guarantors/
credit derivative counterparties
and their creditworthiness; and
Information about (market
or credit) risk concentrations
within the mitigation taken.
Quantitative Disclosure........... (b) For each separately disclosed
portfolio, the total exposure
(after, where applicable, on- or
off-balance sheet netting) that is
covered by guarantees/credit
derivatives and the risk-weighted
asset amount associated with that
exposure.
------------------------------------------------------------------------
---------------------------------------------------------------------------
\34\ At a minimum, a bank holding company must give the
disclosures in Table 11.7 in relation to credit risk mitigation that
has been recognized for the purposes of reducing capital
requirements under this Appendix. Where relevant, bank holding
companies are encouraged to give further information about mitigants
that have not been recognized for that purpose.
\35\ Credit derivatives that are treated, for the purposes of
this Appendix, as synthetic securitization exposures should be
excluded from the credit risk mitigation disclosures and included
within those relating to securitization.
\36\ Counterparty credit risk-related exposures disclosed
pursuant to Table 11.6 should be excluded from the credit risk
mitigation disclosures in Table 11.7.
Table 11.8.--Securitization
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative disclosures........... (a) The general qualitative
disclosure requirement disclosures
with respect to securitization
(including synthetics), including a
discussion of:
The bank holding company's
objectives relating to
securitization activity, including
the extent to which these
activities transfer credit risk of
the underlying exposures away from
the bank holding company to other
entities;
The roles played by the
bank holding company in the
securitization process \37\ and an
indication of the extent of the
bank holding company's involvement
in each of them; and
The regulatory capital
approaches (for example, RBA, IAA
and SFA) that the bank holding
company follows for its
securitization activities.
(b) Summary of the bank holding
company's accounting policies for
securitization activities,
including:
Whether the transactions
are treated as sales or financings;
Recognition of gain-on-
sale;
Key assumptions for valuing
retained interests, including any
significant changes since the last
reporting period and the impact of
such changes; and
Treatment of synthetic
securitizations.
(c) Names of NRSROs used for
securitizations and the types of
securitization exposure for which
each agency is used.
[[Page 55952]]
Quantitative disclosures.......... (d) The total outstanding exposures
securitized by the bank holding
company in securitizations that
meet the operation criteria in
Section 41 (broken down into
traditional/synthetic), by
underlying exposure type.\38, 39,
40\
(e) For exposures securitized by the
bank holding company in
securitizations that meet the
operational criteria in Section 41:
Amount of securitized
assets that are impaired/past due;
and
Losses recognized by the
bank holding company during the
current period \41\ broken down by
exposure type.
(f) Aggregate amount of
securitization exposures broken
down by underlying exposure type.
(g) Aggregate amount of
securitization exposures and the
associated IRB capital charges for
these exposures broken down into a
meaningful number of risk weight
bands. Exposures that have been
deducted from capital should be
disclosed separately by type of
underlying asset.
(h) For securitizations subject to
the early amortisation treatment,
the following items by underlying
asset type for securitized
facilities:
The aggregate drawn
exposures attributed to the
seller's and investors' interests;
and
The aggregate IRB capital
charges incurred by the bank
holding company against the
investor's shares of drawn balances
and undrawn lines.
(i) Summary of current year's
securitization activity, including
the amount of exposures securitized
(by exposure type), and recognised
gain or loss on sale by asset type.
------------------------------------------------------------------------
---------------------------------------------------------------------------
\37\ For example: originator, investor, servicer, provider of
credit enhancement, sponsor of asset backed commercial paper
facility, liquidity provider, swap provider.
\38\ Underlying exposure types may include, for example, 1-4
family residential loans, home equity lines, credit card
receivables, and auto loans.
\39\ Securitization transactions in which the originating bank
holding company does not retain any securitization exposure should
be shown separately but need only be reported for the year of
inception.
\40\ Where relevant, a bank holding company is encouraged to
differentiate between exposures resulting from activities in which
they act only as sponsors, and exposures that result from all other
bank holding company securitization activities.
\41\ For example, charge-offs/allowances (if the assets remain
on the bank holding company's balance sheet) or write-downs of I/O
strips and other residual interests.
Table 11.9.--Operational Risk
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative disclosures........... (a) The general qualitative
disclosure requirement for
operational risk.
(b) Description of the AMA,
including a discussion of relevant
internal and external factors
considered in the bank holding
company's measurement approach.
(c) A description of the use of
insurance for the purpose of
mitigating operational risk.
------------------------------------------------------------------------
Table 11.10.--Equities Not Subject to Market Risk Rule
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative Disclosures........... (a) The general qualitative
disclosure requirement with respect
to equity risk, including:
Differentiation between
holdings on which capital gains
are expected and those taken
under other objectives including
for relationship and strategic
reasons; and
Discussion of important
policies covering the valuation
of and accounting for equity
holdings in the banking book.
This includes the accounting
techniques and valuation
methodologies used, including key
assumptions and practices
affecting valuation as well as
significant changes in these
practices.
Quantitative Disclosures.......... (b) Value disclosed in the balance
sheet of investments, as well as
the fair value of those
investments; for quoted securities,
a comparison to publicly-quoted
share values where the share price
is materially different from fair
value.
(c) The types and nature of
investments, including the amount
that is:
Publicly traded; and
Non-publicly traded.
(d) The cumulative realized gains
(losses) arising from sales and
liquidations in the reporting
period.
(e) Total unrealized gains (losses);
\42\
Total latent revaluation
gains (losses); \43\ and
Any amounts of the above
included in tier 1 and/or tier 2
capital.
(f) Capital requirements broken down
by appropriate equity groupings,
consistent with the bank holding
company's methodology, as well as
the aggregate amounts and the type
of equity investments subject to
any supervisory transition
regarding regulatory capital
requirements. \44\
------------------------------------------------------------------------
---------------------------------------------------------------------------
\42\ Unrealized gains (losses) recognized in the balance sheet
but not through earnings.
\43\ Unrealized gains (losses) not recognized either in the
balance sheet or through earnings.
\44\ This disclosure should include a breakdown of equities that
are subject to the 0%, 20%, 100%, 300%, and 400% risk weights, as
applicable.
Table 11.11.--Interest Rate Risk for Non-Trading Activities
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative disclosures........... (a) The general qualitative
disclosure requirement, including
the nature of interest rate risk
for non-trading activities and key
assumptions, including assumptions
regarding loan prepayments and
behavior of non-maturity deposits,
and frequency of measurement of
interest rate risk for non-trading
activities.
[[Page 55953]]
Quantitative disclosures.......... (b) The increase (decline) in
earnings or economic value (or
relevant measure used by
management) for upward and downward
rate shocks according to
management's method for measuring
interest rate risk for non-trading
activities, broken down by currency
(as appropriate).
------------------------------------------------------------------------
* * * * *
Federal Deposit Insurance Corporation
12 CFR Chapter III
Authority and Issuance
For the reasons stated in the common preamble, the Federal Deposit
Insurance Corporation proposes to amend part 325 of chapter III of
title 12 of the Code of Federal Regulations as follows:
PART 325--CAPITAL MAINTENANCE
1. The authority citation for part 325 continues to read as
follows:
Authority: 12 U.S.C. 1815(a), 1815(b), 1816, 1818(a), 1818(b),
1818(c), 1818(t), 1819(Tenth), 1828(c), 1828(d), 1828(i), 1828(n),
1828(o), 1831o, 1835, 3907, 3909, 4808; Pub. L. 102-233, 105 Stat.
1761, 1789, 1790 (12 U.S.C. 1831n note); Pub. L. 102-242, 105 Stat.
2236, 2355, 2386 (12 U.S.C. 1828 note).
2. New Appendix D to part 325 is added as set forth at the end of
the common preamble.
3. Appendix D to part 325 is amended as set forth below:
a. Remove ``[AGENCY]'' and add ``FDIC'' in its place wherever it
appears.
b. Remove ``[bank]'' and add ``bank'' in its place wherever it
appears, and remove ``[Bank]'' and add ``Bank'' in its place wherever
it appears.
c. Remove ``[Appendix ---- to Part ----]'' and add ``Appendix D to
Part 325'' in its place wherever it appears.
d. Remove ``[the general risk-based capital rules]'' and add ``12
CFR part 325, Appendix A'' in its place wherever it appears.
e. Remove ``[the market risk rule]'' and add ``12 CFR part 325,
Appendix C'' in its place wherever it appears.
f. Remove ``[Disclosure paragraph (b)]'' and add in its place ``(b)
A bank must comply with paragraph (c) of section 71 of appendix F to
the Federal Reserve Board's Regulation Y (12 CFR part 225, appendix F)
unless it is a consolidated subsidiary of a bank holding company or
depository institution that is subject to these requirements.''
g. Remove ``Disclosure paragraph (c)].''
Department of the Treasury
Office of Thrift Supervision
12 CFR Chapter V
Authority and Issuance
For the reasons stated in the common preamble, the Office of Thrift
Supervision proposes to amend part 566 of chapter V of title 12 of the
Code of Federal Regulations as follows:
1. Add a new part 566 to read as follows:
PART 566--ADVANCED CAPITAL ADEQUACY FRAMEWORK AND MARKET RISK
ADJUSTMENT
Sec.
566.1 Purpose
Authority: 12 U.S.C. 1462, 1462a, 1463, 1464, 1467a, 1828(note).
Sec. 566.1 Purpose.
(a) Advanced Capital Framework. Appendix A of this part
establishes: minimum qualifying criteria for savings associations using
internal risk measurement and management processes for calculating risk
based capital requirements, methodologies for these savings
associations to calculate their risk-based capital requirement, and
public disclosure requirements for these savings associations.
(b) [Reserved]
2. Appendix A to part 566 is added to read as set forth at the end
of the common preamble.
3. Appendix A to part 566 is amended as set forth below:
a. Remove ``[AGENCY]'' and add ``OTS'' in its place wherever it
appears.
b. Remove ``[bank]'' and add ``savings association'' in its place
wherever it appears, and remove ``[Bank]'' and add ``Savings
association'' in its place wherever it appears.
c. Remove ``[Appendix----to Part----]'' and add ``Appendix A to
Part 566'' in its place wherever it appears.
d. Remove ``[the general risk-based capital rules]'' and add ``12
CFR part 567'' in its place wherever it appears.
e. Remove ``[the market risk rule]'' and add ``12 CFR part 566,
Subpart B'' in its place wherever it appears.
f. Remove the text of section 12(b) and add in its place: ``A
savings association is not required to deduct equity securities from
capital under 12 CFR 567.5(c)(2)(ii). However, it must continue to
deduct equity investments in real estate under that section. See 12 CFR
567.1, which defines equity investments, including equity securities
and equity investments in real estate.''
g. Remove the text of section 52(b)(3)(i) and add in its place:
``An equity exposure that is designed primarily to promote community
welfare, including the welfare of low- and moderate-income communities
or families, such as by providing services or jobs, excluding equity
exposures to an unconsolidated small business investment company and
equity exposures held through a consolidated small business investment
company described in section 302 of the Small Business Investment Act
of 1958 (15 U.S.C. 682).''
h. Remove ``[Disclosure paragraph (b)]'' and add in its place ``(b)
A savings association must comply with paragraph (c) of section 71
unless it is a consolidated subsidiary of a depository institution or
bank holding company that is subject to these requirements.''
i. Remove ``[Disclosure paragraph (c)].''
j. In section 71, add new paragraph (c) to read as follows:
Section 71 * * *
* * * * *
(c)(1) Each consolidated savings association described in paragraph
(b) of this section that has successfully completed its parallel run
must provide timely public disclosures each calendar quarter of the
information in tables 11.1-11.11 below. If a significant change occurs,
such that the most recent reported amounts are no longer reflective of
the savings association's capital adequacy and risk profile, then a
brief discussion of this change and its likely impact must be provided
as soon as practicable thereafter. Qualitative disclosures that
typically do not change each quarter (for example, a general summary of
the savings association's risk management objectives and policies,
reporting system, and definitions) may be disclosed annually, provided
any significant changes to these are disclosed in the interim.
Management is encouraged to provide all of the disclosures required by
this appendix in one place on the savings association's public Web
site.\45\ The
[[Page 55954]]
savings association must make these disclosures publicly available for
each of the last three years (that is, twelve quarters) or such shorter
period since it began its first floor period.
---------------------------------------------------------------------------
\45\ Alternatively, a savings association may provide the
disclosures in more than one place, as some of them may be included
in public financial reports (for example, in Management's Discussion
and Analysis included in SEC filings) or other regulatory reports.
The savings association must provide a summary table on its public
Website that specifically indicates where all the disclosures may be
found (for example, regulatory report schedules, page numbers in
annual reports).
---------------------------------------------------------------------------
(2) Each savings association is required to have a formal
disclosure policy approved by the board of directors that addresses its
approach for determining the disclosures it makes. The policy must
address the associated internal controls and disclosure controls and
procedures. The board of directors and senior management must ensure
that appropriate verification of the disclosures takes place and that
effective internal controls and disclosure controls and procedures are
maintained. The chief financial officer of the savings association must
certify that the disclosures required by this appendix are appropriate,
and the board of directors and senior management are responsible for
establishing and maintaining an effective internal control structure
over financial reporting, including the disclosures required by this
appendix.
Table 11.1.--Scope of Application
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative Disclosures........... (a) The name of the top corporate
entity in the group to which the
appendix applies.
(b) An outline of differences in the
basis of consolidation for
accounting and regulatory purposes,
with a brief description of the
entities \46\ within the group (a)
that are fully consolidated; (b)
that are deconsolidated and
deducted; (c) for which the
regulatory capital requirement is
deducted; and (d) that are neither
consolidated nor deducted (for
example, where the investment is
risk-weighted).
(c) Any restrictions, or other major
impediments, on transfer of funds
or regulatory capital within the
group.
Quantitative Disclosures.......... (d) The aggregate amount of surplus
capital of insurance subsidiaries
(whether deducted or subjected to
an alternative method) included in
the regulatory capital of the
consolidated group.
(e) The aggregate amount of capital
deficiencies \47\ in all
subsidiaries and the name(s) of
such subsidiaries.
------------------------------------------------------------------------
---------------------------------------------------------------------------
\46\ Entities include securities, insurance and other financial
subsidiaries, commercial subsidiaries (where permitted), significant
minority equity investments in insurance, financial and commercial
entities.
\47\ A capital deficiency is the amount by which actual
regulatory capital is less than the minimum regulatory capital
requirements.
Table 11.2.--Capital Structure
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative disclosures........... (a) Summary information on the terms
and conditions of the main features
of all capital instruments,
especially in the case of
innovative, complex or hybrid
capital instruments.
Quantitative disclosures.......... (b) The amount of tier 1 capital,
with separate disclosure of:
Common stock/surplus;
Retained earnings;
Minority interests in the
equity of subsidiaries;
regulatory calculation
differences deducted from tier 1
capital; \48\ and
Other amounts deducted
from tier 1 capital, including
goodwill and certain intangibles.
(c) The total amount of tier 2
capital.
(d) Other deductions from
capital.\49\
(e) Total eligible capital.
------------------------------------------------------------------------
---------------------------------------------------------------------------
\48\ Representing 50% of the amount, if any, by which total
expected credit losses as calculated within the IRB framework exceed
eligible credit reserves, which must be deducted from Tier 1
capital.
\49\ Including 50% of the amount, if any, by which total
expected credit losses as calculated within the IRB framework exceed
eligible credit reserves, which must be deducted from Tier 2
capital.
Table 11.3.--Capital Adequacy
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative disclosures........... (a) A summary discussion of the
savings association's approach to
assessing the adequacy of its
capital to support current and
future activities.
Quantitative disclosures.......... (b) Risk-weighted assets for credit
risk from:
Wholesale exposures;
Residential mortgage
exposures;
Qualifying revolving
exposures;
Other retail exposures;
Securitization exposures;
and
Equity exposures:
Equity exposures subject
to simple risk weight approach;
and
Equity exposures subject
to internal models approach.
(c) Risk-weighted assets for market
risk as calculated under [the
market risk rule]: \50\
Standardized approach for
specific risk; and
Internal models approach
for specific risk.
(d) Risk-weighted assets for
operational risk.
(e) Total and tier 1 risk-based
capital ratios: \51\
[[Page 55955]]
For the top consolidated
group; and
For each DI subsidiary.
------------------------------------------------------------------------
General Qualitative Disclosure Requirement
---------------------------------------------------------------------------
\50\ Risk-weighted assets determined under [the market risk
rule] are to be disclosed only for the approaches used.
\51\ Total risk-weighted assets should also be disclosed.
---------------------------------------------------------------------------
For each separate risk area described in tables 11.4 through 11.11,
the savings association must describe its risk management objectives
and policies, including:
Strategies and processes;
The structure and organization of the relevant risk
management function;
The scope and nature of risk reporting and/or measurement
systems;
Policies for hedging and/or mitigating risk and strategies
and processes for monitoring the continuing effectiveness of hedges/
mitigants.
Table 11.4.\52\--Credit Risk: General Disclosures
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative Disclosures........... (a) The general qualitative
disclosure requirement with respect
to credit risk (excluding
counterparty credit risk disclosed
in accordance with Table 11.6),
including:
Definitions of past due and
impaired (for accounting purposes);
Description of approaches
followed for allowances, including
statistical methods used where
applicable;
Discussion of the savings
association's credit risk
management policy.
Quantitative Disclosures.......... (b) Total gross credit risk
exposures,\53\ and average gross
credit risk exposures, over the
period broken down by major types
of credit exposure.\54\
(c) Geographic \55\ distribution of
exposures, broken down in
significant areas by major types of
credit exposure.
(d) Industry or counterparty type
distribution of exposures, broken
down by major types of credit
exposure.
(e) Remaining contractual maturity
breakdown (for example, one year or
less) of the whole portfolio,
broken down by major types of
credit exposure.
(f) By major industry or
counterparty type:
Amount of impaired loans;
Amount of past due
loans;\56\ Allowances; and
Charge-offs during the
period.
(g) Amount of impaired loans and, if
available, the amount of past due
loans broken down by significant
geographic areas including, if
practical, the amounts of
allowances related to each
geographical area.\57\
(h) Reconciliation of changes in the
allowance for loan and lease
losses.\58\
------------------------------------------------------------------------
---------------------------------------------------------------------------
\52\ Table 4 does not include equity exposures.
\53\ That is, after accounting offsets in accordance with US
GAAP (for example, FASB Interpretations 39 and 41) and without
taking into account the effects of credit risk mitigation
techniques, for example collateral and netting.
\54\ For example, banks could apply a breakdown similar to that
used for accounting purposes. Such a breakdown might, for instance,
be (a) loans, off-balance sheet commitments, and other non-
derivative off-balance sheet exposures, (b) debt securities, and (c)
OTC derivatives.
\55\ Geographical areas may comprise individual countries,
groups of countries or regions within countries. A savings
association might choose to define the geographical areas based on
the way the company's portfolio is geographically managed. The
criteria used to allocate the loans to geographical areas must be
specified.
\56\ A savings association is encouraged also to provide an
analysis of the aging of past-due loans.
\57\ The portion of general allowance that is not allocated to a
geographical area should be disclosed separately.
\58\ The reconciliation should include the following: A
description of the allowance; the opening balance of the allowance;
charge-offs taken against the allowance during the period; amounts
provided (or reversed) for estimated probable loan losses during the
period; any other adjustments (for example, exchange rate
differences, business combinations, acquisitions and disposals of
subsidiaries), including transfers between allowances; and the
closing balance of the allowance. Charge-offs and recoveries that
have been recorded directly to the income statement should be
disclosed separately.
Table 11.5.--Credit Risk: Disclosures for Portfolios Subject to IRB Risk-
Based Capital Formulas
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative disclosures........... (a) Explanation and review of the:
Structure of internal
rating systems and relation between
internal and external ratings;
Use of risk parameter
estimates other than for regulatory
capital purposes;
Process for managing and
recognizing credit risk mitigation;
and
Control mechanisms for the
rating system, including discussion
of independence, accountability,
and rating systems review.
(b) Description of the internal
ratings process, provided
separately for the following:
Wholesale category; and
Retail subcategories:
residential mortgage exposures;
Qualifying revolving
exposures; and
Other retail exposures.
For each category and subcategory
the description should include:
The types of exposure
included in the category/
subcategories;
The definitions, methods
and data for estimation and
validation of PD, ELGD, LGD, and
EAD, including assumptions employed
in the derivation of these
variables.\59\
Quantitative Disclosures: Risk (c) For wholesale exposures, present
Assessment. the following information across a
sufficient number of PD grades
(including default) to allow for a
meaningful differentiation of
credit risk: \60\
Total EAD; \61\
Exposure-weighted average ELGD and
LGD (percentage);
Exposure weighted-average
capital requirement (K); and
[[Page 55956]]
Amount of undrawn
commitments and exposure-weighted
average EAD for wholesale
exposures.
For each retail subcategory, present
the disclosures outlined above
across a sufficient number of
segments to allow for a meaningful
differentiation of credit risk.
Quantitative disclosures: (d) Actual losses in the preceding
historical results. period for each category and
subcategory and how this differs
from past experience. A discussion
of the factors that impacted the
loss experience in the preceding
period--for example, has the
savings association experienced
higher than average default rates,
loss rates or EADs.
(e) Comparison of risk parameter
estimates against actual outcomes
over a longer period.\62\ At a
minimum, this should include
information on estimates of losses
against actual losses in the
wholesale category and each retail
subcategory over a period
sufficient to allow for a
meaningful assessment of the
performance of the internal rating
processes for each category/
subcategory.\63\ Where appropriate,
the savings association should
further decompose this to provide
analysis of PD, ELGD, LGD, and EAD
outcomes against estimates provided
in the quantitative risk assessment
disclosures above.\64\
------------------------------------------------------------------------
---------------------------------------------------------------------------
\59\ This disclosure does not require a detailed description of
the model in full--it should provide the reader with a broad
overview of the model approach, describing definitions of the
variables, and methods for estimating and validating those variables
set out in the quantitative risk disclosures below. This should be
done for each of the four category/subcategories. The savings
association should disclose any significant differences in approach
to estimating these variables within each category/subcategories.
\60\ The PD, ELGD, LGD and EAD disclosures in Table 11.5(c)
should reflect the effects of collateral, qualifying master netting
agreements, eligible guarantees and eligible credit derivatives as
defined in Part 1. Disclosure of each PD grade should include the
exposure weighted-average PD for each grade. Where a savings
association aggregates PD grades PD for the purposes of disclosure,
this should be a representative breakdown of the distribution of PD
grades used for regulatory capital purposes.
\61\ Outstanding loans and EAD on undrawn commitments can be
presented on a combined basis for these disclosures.
\62\ These disclosures are a way of further informing the reader
about the reliability of the information provided in the
``quantitative disclosures: risk assessment'' over the long run. The
disclosures are requirements from year-end 2010; in the meantime,
early adoption is encouraged. The phased implementation is to allow
a savings association sufficient time to build up a longer run of
data that will make these disclosures meaningful.
\63\ This regulation is not prescriptive about the period used
for this assessment. Upon implementation, it might be expected that
a savings association would provide these disclosures for as long
run of data as possible--for example, if a savings association has
10 years of data, it might choose to disclose the average default
rates
\64\ A savings association should provide this further
decomposition where it will allow users greater insight into the
reliability of the estimates provided in the ``quantitative
disclosures: risk assessment.'' In particular, it should provide
this information where there are material differences between its
estimates of PD, ELGD, LGD or EAD compared to actual outcomes over
the long run. The savings association should also provide
explanations for such differences.
Table 11.6.--General Disclosure for Counterparty Credit Risk-Related
Exposures
------------------------------------------------------------------------
------------------------------------------------------------------------
Qualitative Disclosures........... (a) The general qualitative
disclosure requirement with respect
to OTC derivatives, eligible margin
loans, and repo-style transactions,
including:
Discussion of methodology
used to assign economic capital
and credit limits for
counterparty credit exposures;
Discussion of policies
for securing collateral, valuing
and managing collateral, and
establishing credit reserves;
Discussion of the primary
types of collateral taken;
Discussion of policies
with respect to wrong-way risk
exposures; and
Discussions of the impact
of the amount of collateral the
bank would have to provide given
a credit rating downgrade.
Quantitative Disclosures.......... (b) Gross positive fair value of
contracts, netting benefits, netted
current credit exposure, collateral
held (including type, for example,
cash, government securities), and
net unsecured credit exposure.\65\
Also report measures for EAD used
for regulatory capital for these
transactions, the notional value of
credit derivative hedges purchased
for counterparty credit risk
protection, and the distribution of
current credit exposure by types of
credit exposure.\66\
(c) Notional amount of purchased and
sold credit derivatives, segregated
between use for the institution's
own credit portfolio, as well as in
its intermediation activities,
including the distribution of the
credit derivative products used,
broken down further by protection
bought and sold within each product
group.
(d) The estimate of alpha if the
savings association has received
supervisory approval to estimate
alpha.
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\65\ Net unsecured credit exposure is the cedit exposure after
considering both the benefits from legally enforceable netting
agreements and collateral arrangements without taking into account
haircuts for price volatility, liquidity, etc.
\66\ This may include interest rate derivative contracts,
foreign exchange derivative contracts, equity derivative contracts,
credit derivatives, commodity or other derivative contracts, repo-
style transactions, and eligible margin loans.
Table 11.7.--Credit Risk Mitigation67 68 69
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Qualitative Disclosures........... (a) The general qualitative
disclosure requirement with respect
to credit risk mitigation
including:
Policies and processes
for, and an indication of the
extent to which the savings
association uses, on- and off-
balance sheet netting;
Policies and processes
for collateral valuation and
management;
A description of the main
types of collateral taken by the
savings association;
The main types of
guarantors/credit derivative
counterparties and their
creditworthiness; and
Information about (market
or credit) risk concentrations
within the mitigation taken.
[[Page 55957]]
Quantitative Disclosures.......... (b) For each separately disclosed
portfolio, the total exposure
(after, where applicable, on- or
off-balance sheet netting) that is
covered by guarantees/credit
derivatives and the risk-weighted
asset amount associated with that
exposure.
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\67\ At a minimum, a savings association must give the
disclosures in Table 11.7 in relation to credit risk mitigation that
has been recognized for the purposes of reducing capital
requirements under this Appendix. Where relevant, savings
associations are encouraged to give further information about
mitigants that have not been recognized for that purpose.
\68\ Credit derivatives that are treated, for the purposes of
this Appendix, as synthetic securitization exposures should be
excluded from the credit risk mitigation disclosures and included
within those relating to securitization.
\69\ Counterparty credit risk-related exposures disclosed
pursuant to Table 11.6 should be excluded from the credit risk
mitgation disclosures in Table 11.7.
Table 11.8.--Securitization
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Qualitative Disclosures........... (a) The general qualitative
disclosure requirement with respect
to securitization (including
synthetics), including a discussion
of:
The savings association's
objectives relating to
securitization activity,
including the extent to which
these activities transfer credit
risk of the underlying exposures
away from the savings association
to other entities;
The roles played by the
savings association in the
securitization process \70\ and
an indication of the extent of
the savings association's
involvement in each of them; and
The regulatory capital
approaches (for example, RBA, IAA
and SFA) that the savings
association follows for its
securitization activities.
(b) Summary of the savings
association's accounting policies
for securitization activities,
including:
Whether the transactions
are treated as sales or
financings;
Recognition of gain-on-
sale;
Key assumptions for
valuing retained interests,
including any significant changes
since the last reporting period
and the impact of such changes;
and
Treatment of synthetic
securitizations.
(c) Names of NRSROs used for
securitizations and the types of
securitization exposure for which
each agency is used.
Quantitative Disclosures.......... (d) The total outstanding exposures
securitized by the savings
association in securitizations that
meet the operation criteria in
Section 41 (broken down into
traditional/synthetic), by
underlying exposure type.71,72,73
(e) For exposures securitized by the
savings association in
securitizations that meet the
operational criteria in Section 41:
Amount of securitized
assets that are impaired/past
due; and
Losses recognized by the
savings association during the
current period \74\ broken down
by exposure type.
(f) Aggregate amount of
securitization exposures broken
down by underlying exposure type.
(g) Aggregate amount of
securitization exposures and the
associated IRB capital charges for
these exposures broken down into a
meaningful number of risk weight
bands. Exposures that have been
deducted from capital should be
disclosed separately by type of
underlying asset.
(h) For securitizations subject to
the early amortisation treatment,
the following items by underlying
asset type for securitized
facilities:
The aggregate drawn
exposures attributed to the
seller's and investors'
interests; and
The aggregate IRB capital
charges incurred by the savings
association against the
investor's shares of drawn
balances and undrawn lines.
(i) Summary of current year's
securitization activity, including
the amount of exposures securitized
(by exposure type), and recognised
gain or loss on sale by asset type.
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\70\ For example: Originator, investor, servicer, provider of
credit enhancement, sponsor of asset backed commercial paper
facility, liquidity provider, swap provider.
\71\ Underlying exposure types may include, for example, 1-4
family residential loans, from equity lines, credit card
receivables, and auto loans.
\72\ Securitization transactions in which the originating
savings association does not retain any securitization exposure
should be shown separately but need only be reported for the year of
inception.
\73\ Where relevant, a savings association is encouraged to
differentiate between exposures resulting from activities in which
they act only as sponsors, and exposures that result from all other
savings association securitization activities.
\74\ For example, charge-offs/allowances (if the assets remain
on the savings association's balance sheet) or write-downs of I/O
strips and other residual interests.
Table 11.9.--Operational Risk
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Qualitative Disclosures........... (a) The general qualitative
disclosure requirement for
disclosures operational risk.
(b) Description of the AMA,
including a discussion of relevant
internal and external factors
considered in the savings
association's measurement approach.
(c) A description of the use of
insurance for the purpose of
mitigating operational risk.
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[[Page 55958]]
Table 11.10.--Equities Not Subject to Market Risk Rule
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Qualitative Disclosures........... (a) The general qualitative
disclosure requirement with respect
to equity risk, including:
Differentiation between
holdings on which capital gains
are expected and those taken
under other objectives including
for relationship and strategic
reasons; and
Discussion of important
policies covering the valuation
of and accounting for equity
holdings in the banking book.
This includes the accounting
techniques and valuation
methodologies used, including key
assumptions and practices
affecting valuation as well as
significant changes in these
practices.
Quantitative Disclosures.......... (b) Value disclosed in the balance
sheet of investments, as well as
the fair value of those
investments; for quoted securities,
a comparison to publicly-quoted
share values where the share price
is materially different from fair
value.
(c) The types and nature of
investments, including the amount
that is:
Publicly traded; and
Non-publicly traded.
(d) The cumulative realized gains
(losses) arising from sales and
liquidations in the reporting
period.
(e) Total unrealized gains
(losses); \75\
Total latent revaluation
gains (losses); \76\ and
Any amounts of the above
included in tier 1 and/or tier 2
capital.
(f) Capital requirements broken down
by appropriate equity groupings,
consistent with the savings
association's methodology, as well
as the aggregate amounts and the
type of equity investments subject
to any supervisory transition
regarding regulatory capital
requirements.\77\
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Table 11.11.--Interest Rate Risk for Non-Trading Activities
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Qualitative disclosures........... (a) The general qualitative
disclosure requirement, including
the nature of interest rate risk
for non-trading activities and key
assumptions, including assumptions
regarding loan prepayments and
behavior of non-maturity deposits,
and frequency of measurement of
interest rate risk for non-trading
activities.
Quantitative disclosures.......... (b) The increase (decline) in
earnings or economic disclosures
value (or relevant measure used by
management) for upward and downward
rate shocks according to
management's method for measuring
interest rate risk for non-trading
activities, broken down by currency
(as appropriate).
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* * * * *
Dated: September 5, 2006.
John C. Dugan,
Comptroller of the Currency.
By order of the Board of Governors of the Federal Reserve
System, September 11, 2006.
Jennifer J. Johnson,
Secretary of the Board.
Dated at Washington, DC, this 5th day of September, 2006.
By order of the Board of Directors.
Federal Deposit Insurance Corporation.
Robert E. Feldman,
Executive Secretary.
Dated: September 5, 2006.
By the Office of Thrift Supervision.
John M. Reich,
Director.
[FR Doc. 06-7656 Filed 9-22-06]
BILLING CODES 4810-33-P, 6210-01-P, 6714-01-P, 6720-01-P